What Are Mutual Funds?

In the intricate world of personal finance, there are many terms that people have heard but don’t fully understand. One such phrase is mutual funds, which is a complicated yet valuable way for people to invest their money. If you’re one of those people who doesn’t fully grasp mutual funds, it’s worth your time to take a few minutes and learn about what mutual funds are, how mutual funds work — and how mutual funds can benefit you financially.

What Is a Mutual Fund?

A mutual fund is a type of investment that allows you to pool money with other shareholders to purchase a bundle of stocks, bonds or other securities. This pooling of these funds makes it easier for individual investors to own a diverse mix of investments rather than just a few.

Because mutual funds contain many different holdings, they help reduce your risk compared to if you just put money into individual stocks or bonds. If you just own one stock and it dips, your value has decreased. But because mutual funds are diverse, they may provide more consistent returns by spreading your investment across a variety of companies and sectors.

How Do Mutual Funds Work?

Mutual funds are investment pools that you participate in with other investors through a brokerage and a money manager. Your money manager can help you decide what securities to purchase and when to sell the individual securities in the fund, and you receive the income from the sales or returns.

Many employers offer retirement plans like 401(k)s that allow you to invest in mutual funds directly via your paycheck. You can also open an account with a mutual fund company or brokerage firm and make contributions on your own.

Mutual funds are typically operated by money managers who decide which specific stocks, bonds or other securities to include in the fund’s portfolio. Some funds have a more specific goal, such as green energy or artificial intelligence, while others may focus on returns via something like smaller companies that seem likely to grow.

A fund’s manager oversees its holdings, and the work typically includes research, trading and rebalancing the portfolio. As a fund holder, you receive shares representing your stake and the fund’s value, and your returns rise or fall daily based on the performance of the fund’s investments.

How Do You Earn Money from Mutual Funds?

The overall goal of a mutual fund is to help you, the fund holder, earn money. Here’s how that happens:

Dividend Payments

Dividends are cash payments based on a company’s profits that companies distribute to their investors on a predetermined schedule, typically quarterly. They act as a reward for shareholders, and the amount of dividend you receive is based on how many shares you own. 

To put it simply, the more stocks you own, the larger the dividend payment you will earn. However, not all stocks offer this option, so it’s important to research whether a particular stock offers dividend payments before investing.

Capital Gains

This is the method of earning income people envision when they buy a stock: in other words, buy low/sell high. So when you earn capital gains, that refers to the profits you make when you sell an investment for more than you originally paid for it. For example, let’s say you bought $1,000 worth of stock and it increased in value by 20%. If you sold it for $1,200, you would have earned a capital gain of $200.

Interest Income

When you invest in a mutual fund that holds bonds or other debt securities, that fund earns interest income. The fund then passes along a portion of that interest income to you. The amount of income you receive depends on the interest earned by the fund’s holdings and the number of fund shares you own.

Selling Your Shares

In an ideal scenario, you own shares of a mutual fund and its value increases. If that happens, you can sell your shares for a profit. To do that, you submit a sell order to the fund company or your investment manager. That sell order specifies the dollar amount, or number of shares, you wish to liquidate. When that goes through, you will receive the net asset value for those shares.

What to Consider Before Choosing a Mutual Fund

Investing your money brings the possibility of increasing it … but also losing some of it. So start the process of choosing a mutual fund by ensuring you have enough money to weather a loss. Once you’re set here, do your research to find which type of stocks you’d like to make up your fund, and be sure your fund is diverse. Then look for a successful, ethical brokerage to work with, and look at their fees to ensure your money is being utilized efficiently.

Types Of Mutual Funds

There are many different types of mutual funds available for investors. Here are the primary funds you can choose:

• Actively managed funds: These are funds where the holdings are continually monitored and adjusted by professional fund managers, who actively research, pick and choose which specific stocks, bonds or other securities to include in the fund’s portfolio.
• Indexed funds: These funds are invested in stocks that emulate the performance of a specific market index, such as the S&P 500 or the NASDAQ. In other words, instead of being made of up stocks, an indexed fund is passively invested in the same securities — and to the same proportions — as the underlying index it tracks.
• Stock funds: These are funds that are invested in the stocks of various companies and can be specified to track particular industries, such as growth funds (companies with high growth potential), value funds (undervalued companies) or blend funds (a mix of growth and value stocks).
• Bond funds: These are funds that are invested primarily in various fixed-income securities, such as government bonds, corporate bonds and municipal bonds.
• Balanced funds: These are funds that are invested in a combination of both stocks and bonds, with the goal of providing a combination of potential growth with stable income.

Fees on Mutual Funds

It takes a lot of people to maintain the day-to-day management of mutual funds, including managers, accountants, lawyers and others. The funds are typically assessed based on a percentage of your investment, as well as one-time fees when you buy or sell shares in a mutual fund. There are also “sales load” fees, which are assessed when you buy or sell shares.

Are Mutual Funds and ETFs The Same Thing?

Mutual funds and exchange-traded funds (ETFs) are similar forms of investment in that they are managed pools of individual securities that allow investors to diversify their options, but there are many other ways mutual funds differ from ETFs.

When to Choose a Mutual Fund over an ETF

If you’re looking for someone to actively manage a fund, which brings the potential for positive performance through a fund manager’s expertise, a mutual fund may be a better choice than a passively managed ETF. Mutual funds can also be better choices for people wanting to make regular, smaller investments, because investors can buy fractional shares without the need for whole-share purchases like with ETFs.

This chart illustrates other differences between mutual funds and ETFs:

FAQs About Mutual Funds

Given the complexity of mutual funds, it’s understandable that people have questions about them. Here are some of the more common ones:

How long should I keep money in a mutual fund?

The ideal holding period for a mutual fund depends on your goals and the fund’s investment strategy, but the conventional wisdom recommends a period of at least five years to allow the fund's performance to play out and benefit from compounding returns. For mutual funds with upfront sales charges or loads, holding the fund for a longer period can help justify these costs by allowing more time for potential gains to accumulate.

Do all mutual funds charge fees?

Yes. Maintaining a mutual fund incurs costs, so it is only logical that buyers would be charged fees to keep the fund running.

Are mutual funds a good investment?

The short answer: it depends. As with any investment, there are risks. Because mutual funds tend to be diversified, the risks are spread out and can be lower than other investments — but clearly risks are still present. Take your time and do your due diligence to determine whether you can tolerate the potential depreciation of your investment.

The Bottom Line

Mutual funds can be a good way to invest your money and potentially increase your net worth. But it takes a good knowledge of the financial world and strong command of your finances to make the right decisions. A key part of this would be getting a better view of your financial life, so download the Rocket Money^SM app to master your finances today!