What Is a Mutual Fund?

A mutual fund is a type of financial vehicle made up of a pool of money collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments, and other assets. Mutual funds are operated by professional money managers, who allocate the fund's assets and attempt to produce capital gains and/or income for the fund's investors. A mutual fund's portfolio is structured and maintained to match the investment objectives stated in its prospectus.

Mutual funds give small or individual investors access to professionally managed portfolios of equities, bonds and other securities. Each shareholder, therefore, participates proportionally in the gains or losses of the fund. Mutual funds invest in a wide amount of securities, and performance is usually tracked as the change in the total market cap of the fund, derived by the aggregating performance of the underlying investments.

The Basics of a Mutual Fund

Mutual funds pool money from the investing public and use that money to buy other securities, usually stocks and bonds. The value of the mutual fund company depends on the performance of the securities it decides to buy. So when you buy a unit or share of a mutual fund, you are actually buying the performance of its portfolio or more precisely, a part of the portfolio's value.

That's why the price of a mutual fund share is referred to as the net asset value (NAV) per share, sometimes expressed as NAVPS. A fund's NAV is derived by dividing the total value of the securities in the portfolio by the total amount of shares outstanding. Mutual fund shares can typically be purchased or redeemed as needed at the fund's current NAV, which—unlike a stock price—doesn't fluctuate during market hours, but is settled at the end of each trading day.

The average mutual fund holds hundreds of different securities, which means mutual fund shareholders gain important diversification at a very low price. Consider an investor who just buys Google stock before the company has a bad quarter. He stands to lose a great deal of value because all of his dollars are tied to one company. On the other hand, a different investor may buy shares of a mutual fund that happens to own some Google stock. When Google has a bad quarter, she only loses a fraction as much because Google is just a small part of the fund's portfolio.

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How Mutual Funds Work

A mutual fund is both an investment and an actual company. This may seem strange, but it is actually no different than how a share of AAPL is a representation of Apple, Inc. When an investor buys Apple stock, he is buying part ownership of the company and its assets. Similarly, a mutual fund investor is buying part ownership of the mutual fund company and its assets. The difference is Apple is in the business of making smartphones and tablets, while a mutual fund company is in the business of making investments.

If a mutual fund is a virtual company, its CEO is the fund manager, sometimes called its investment adviser. The fund manager is hired by a board of directors and is legally obligated to work in the best interest of mutual fund shareholders. Most fund managers are also owners of the fund.

There are very few other employees in a mutual fund company. The investment adviser or fund manager may employ some analysts to help pick investments or perform market research. A fund accountant is kept on staff to calculate the fund's NAV, the daily value of the portfolio that determines if share prices go up or down. Mutual funds need to have a compliance officer or two, and probably an attorney, to keep up with government regulations.

Most mutual funds are part of a much larger investment company; the biggest have hundreds of separate mutual funds. Some of these fund companies are names familiar to the general public, such as Fidelity Investments, the Vanguard Group, T. Rowe Price and Oppenheimer Funds.

Types of Mutual Funds

Mutual funds are divided into several kinds of categories, representing the kinds of securities they have targeted for their portfolios.

Equity Funds

The largest category is that of equity or stock funds. As the name implies, this sort of fund invests principally in stocks. Within this group are various sub-categories. Some equity funds are named for the size of the companies they invest in: small-, mid- or large-cap. Others are named by their investment approach: aggressive growth, income-oriented, value, etc. Equity funds are also categorized by whether they invest in domestic (U.S.) stocks or foreign equities.

Fixed-Income Funds

Another big group is the fixed income category. A fixed income mutual fund focuses on investments that pay a set rate of return, such as government bonds, corporate bonds or other debt instruments. The idea is the fund portfolio generates a lot of interest income, which can then be passed on to shareholders.

Index Funds

Another group, which has become extremely popular in the last few years, falls under the moniker "index funds." Their investment strategy is based on the belief that it is very hard, and often expensive, to try to consistently beat the market. So the index fund manager simply buys stocks that correspond with a major market index such as the S&P 500 or the Dow Jones Industrial Average. This strategy requires less research from analysts and advisors, so there are fewer expenses to eat up returns before they are passed on to shareholders. These funds are often designed with cost-sensitive investors in mind.

Balanced Funds

Balanced funds invest in both stocks and bonds with the aim of reducing the risk of exposure to one asset class or another. Another name for this type is "asset allocation fund." An investor may expect to find the allocation of these funds among asset classes relatively unchanging, though it will differ among funds. Though their goal is asset appreciation with lower risk, these funds carry the same risk and can be as subject to fluctuation as other classifications of funds. 

Other common types of mutual funds are money market funds, sector funds, alternative funds, smart-beta funds, target-date funds, and even funds-of-funds, or mutual funds that buy shares of other mutual funds.

Mutual Fund Fees

In mutual funds, fees are classified into two categories: annual operating fees and shareholder fees. The annual fund operating fees are charged as an annual percentage of funds under management, usually ranging from 1-3%. The shareholder fees, which come in the form of sales charges, commissions and redemption fees, are paid directly by investors when purchasing or selling the funds.

Annual operating fees are collectively known as the expense ratio. A fund's expense ratio is the summation of its advisory fee or management fee and its administrative costs. Sales charges or commissions are known as "the load" of a mutual fund. When a mutual fund has a front-end load, fees are assessed when shares are purchased. For a back-end load, mutual fund fees are assessed when an investor sells his shares.

Sometimes, however, an investment company offers a no-load mutual fund, which doesn't carry any commission or sales charge. These funds are distributed directly by an investment company rather than through a secondary party.

Some funds also charge fees and penalties for early withdrawals.

Classes of Mutual Fund Shares

Mutual fund shares come in several classes. Their differences reflect the number and size of fees associated with them.

Currently, most individual investors purchase mutual funds with A shares through a broker. This purchase includes a front-end load of up to 5% or more, plus management fees and ongoing fees for distributions, also known as 12b-1 fees. To top it off, loads on A shares vary quite a bit, which can create a conflict of interest. Financial advisors selling these products may encourage clients to buy higher-load offerings to bring in bigger commissions for themselves.

In addition, the rise of exchange-traded funds, which have much lower fees thanks to their passive management structure, have been giving mutual funds considerable competition for investors' dollars. Articles in the financial media about how fund expense ratios and loads can eat into rates of return have also stirred negative feelings about mutual funds.

To remedy these problems and meet fiduciary-rule standards, investment companies have started designating new share classes, including "level load” C shares, which generally don’t have a front-end load but carry a 1% 12b-1 annual distribution fee. (Back-end load shares are called Class B.) The newest class, developed in 2016, consists of clean shares. Clean shares do not have front-end sales loads or annual 12b-1 fees for fund services. American Funds, Janus and MFS are all fund companies currently offering clean shares.

By standardizing fees and loads, the new classes enhance transparency for mutual fund investors. And of course, save them money. For example, an investor who rolls $10,000 into an individual retirement account (IRA) with a clean-share fund could earn nearly $1,800 more over a 30-year period as compared to an average A-share fund, according to an April 2017 Morningstar report, co-authored by Aron Szapiro, Morningstar director of policy research, and Paul Ellenbogen, head of global regulatory solutions.

Advantages of Mutual Funds

There are a variety of reasons that mutual funds have been the retail investor's vehicle of choice for decades. In fact, the overwhelming majority of money in employer-sponsored retirement plans goes into mutual funds.

Diversification

Diversification, or the mixing of investments and assets within a portfolio to reduce risk, is one of the advantages of investing in mutual funds. Buying individual company stocks in retail and offsetting them with industrial sector stocks, for example, offers some diversification. But a truly diversified portfolio has securities with different capitalizations and industries and bonds with varying maturities and issuers. Buying a mutual fund can achieve diversification cheaper and faster than by buying individual securities.

Easy Access

Trading on the major stock exchanges, mutual funds can be bought and sold with relative ease, making them highly liquid investments. And, when it comes to certain types of assets, like foreign equities or exotic commodities, mutual funds are often the most feasible way—in fact, sometimes the only way—for individual investors to participate.

Economies of Scale

Mutual funds also provide economies of scale. Buying one spares the investor of the numerous commission charges needed to create a diversified portfolio. Buying only one security at a time leads to large transaction fees, which will eat up a good chunk of the investment. Also, the $100 to $200 an individual investor might be able to afford is usually not enough to buy a round lot of a stock, but it will buy many mutual fund shares. The smaller denominations of mutual funds allow investors to take advantage of dollar cost averaging.

Professional Management

Most private, non-institutional money managers deal only with high net worth individuals – people with six figures (at least) to invest. But mutual funds, as noted above, require much lower investment minimums. So these funds provide a low-cost way for individual investors to experience (and hopefully benefit from) professional money management.

Freedom of Choice

Investors have the freedom to research and select from managers with a variety of styles and management goals. For instance, a fund manager may focus on value investing, growth investing, developed markets, emerging markets, income or macroeconomic investing, among many other styles. One manager may also oversee funds that employ several different styles. 

Pros

  • Liquidity

  • Diversification

  • Minimal investment requirements

  • Professional management

  • Variety of offerings

Cons

  • High fees, commissions, other expenses

  • Large cash presence in portfolios

  • No FDIC coverage

  • Difficulty in comparing funds

  • Lack of transparency in holdings

Disadvantages of Mutual Funds

Liquidity, diversification, professional management: All these factors make mutual funds attractive options for younger, novice and other individual investors who don't want to actively manage their money. But no asset is perfect, and mutual funds have drawbacks too.

Fluctuating Returns

Like many other investments without a guaranteed return, there is always the possibility that the value of your mutual fund will depreciate. Equity mutual funds experience price fluctuations, along with the stocks that make up the fund. The Federal Deposit Insurance Corporation (FDIC) does not back up mutual fund investments, and there is no guarantee of performance with any fund. Of course, almost every investment carries risk. But it's especially important for investors in money market funds to know that, unlike their bank counterparts, these will not be insured by the FDIC.

Heavy Cash Supplies

Mutual funds pool money from thousands of investors, so every day people are putting money into the fund as well as withdrawing it. To maintain the capacity to accommodate withdrawals, funds typically have to keep a large portion of their portfolios in cash. Having ample cash is great for liquidity, but money sitting around as cash is not working for you and thus is not very advantageous.

High Costs

Mutual funds provide investors with professional management, but it comes at a cost—those expense ratios mentioned earlier. These fees reduce the fund's overall payout, and they're assessed to mutual fund investors regardless of the performance of the fund. As you can imagine, in years when the fund doesn't make money, these fees only magnify losses.

Diworsifcation

Many mutual fund investors tend to overcomplicate matters—that is, they acquire too many funds that are highly related and, as a result, don't get the risk-reducing benefits of diversification; in fact, they have made their portfolio more exposed, a syndrome called diworsification. At the other extreme, just because you own mutual funds doesn't mean you are automatically diversified. For example, a fund that invests only in a particular industry sector or region is still relatively risky.

Lack of Transparency

One thing that can lead to diworsification is the fact that a fund's purpose or makeup isn't always clear. Fund advertisements can guide investors down the wrong path. The Securities and Exchange Commission (SEC) requires that funds have at least 80% of assets in the particular type of investment implied in their names; how the remaining assets are invested is up to the fund manager. However, the different categories that qualify for the required 80% of the assets may be vague and wide-ranging. A fund can, therefore, manipulate prospective investors via its title: A fund that focuses narrowly on Congo stocks, for example, could be sold with a far-ranging title "International High-Tech Fund."

Evaluating Funds

Researching and comparing funds can be difficult. Unlike stocks, mutual funds do not offer investors the opportunity to juxtapose the P/E ratio, sales growth, earnings per share, etc. A mutual fund's net asset value can offer some basis for comparison, but given the diversity of portfolios, comparing the proverbial apples to apples can be difficult, even among funds with similar names or stated objectives. Only index funds tracking the same markets tend to be truly comparable.