Guide to mutual funds: What are they and how do they work?

In a nutshell

Mutual funds are a common type of investment vehicle used by investors in taxable accounts, IRAs, and 401(k) plans. Mutual funds come in a wide variety of investment styles and objectives.

What is a mutual fund?

According to the Securities and Exchange Commission (SEC), “A mutual fund is a company that brings together money from many people and invests it in stocks, bonds or other assets. The combined holdings of stocks, bonds or other assets the fund owns are known as its portfolio. Each investor in the fund owns shares, which represent a part of these holdings.”

Mutual funds are professionally managed pools of investor money. The fund manager may invest passively to track an index like the S&P 500. Or they may invest in an active fashion based on their investment strategy for stocks or bonds. The goal of an actively managed fund is to provide a better return than the market based on the fund’s investing strategy.

How do mutual funds work?

Mutual funds pool the assets of investors to buy various types of securities. The types of securities will be determined by the fund’s objective and investment style. There are mutual funds that invest in stocks, bonds, and short-term money market instruments.

Investors buy shares in mutual funds by investing a set amount of cash. Mutual funds are valued at the end of each trading day, and the amount of cash invested will go towards the purchase of the number of shares covered by the amount of cash invested. The investor then owns that number of shares in the fund.

Mutual funds have a net asset value (NAV) that changes each trading day. The net asset value is the per share price of shares in the fund. The NAV is calculated as follows:

$NAV=\bigg(\dfrac{Fund ;assets ;– ;liabilities}{Total ;number ;of ;outstanding ;shares}\bigg)$

Types of mutual funds

Mutual funds come in a number of varieties across a number of strategies and investing styles.

Equity funds

Equity mutual funds invest in stocks. These funds can hold domestic or international stocks or a combination of the two. The fund might invest in large-cap (companies with a large market capitalization), mid-cap, or small-cap stocks. Morningstar is a major provider of investment research. Its equity style box divides asset classes by size and investing style.

For example, a mutual fund like the Vanguard 500 Investor (ticker VFINX) is in the “large blend” style box. It invests in the stocks in the Standard & Poor’s 500 Index that represents U.S. large-capitalization stocks. Some of those stocks are “value” stocks, and some are “growth” stocks.

These style boxes and others translate to investment categories as defined by Morningstar and others. These classifications allow investors to compare different mutual funds that fall into these various categories against their peers when deciding where to invest their money.

Bond funds

Bond or fixed-income mutual funds invest in various types of bonds. There are bond index funds that invest in various bond-related indexes, and there are actively managed bond mutual funds. There are bond funds that invest in Treasury bonds, other government bonds, corporate bonds, and municipal bonds, among others.

Additionally, there are bond funds investing in short-term bonds, intermediate-term bonds, and long-term bonds. There are also funds that invest in non-U.S. bond holdings.

One note for investors: unlike individual bonds, bond mutual funds never mature. This means rising or falling interest rates will have a greater impact on the value of the fund than on the price and return on individual bonds.

Index funds vs. actively managed funds

Index mutual funds are passively managed. The fund manager attempts to track the holdings and the performance of a stock or bond market index. The Vanguard 500 Index fund mentioned above seeks to replicate the holdings and performance of the S&P 500 index.

The fund manager will buy and sell holdings in the fund to replicate the percentage of each stock in the index on a periodic basis. They will also buy or sell entire positions when the S&P changes the components in the index.

With an actively managed mutual fund, the fund manager is making affirmative decisions as to which stocks or bonds to hold in the fund based on the fund’s objectives and its own analytical process. The American Funds Washington Mutual F2 fund (ticker WMFFX) is an actively managed fund in the large blend asset class. The managers of the fund decide which stocks to own and which ones not to own.

One key advantage of index funds is that they tend to have lower expenses. This is in large part due to the fact that they tend to trade less frequently than actively managed funds. This also tends to make them more tax efficient because less frequent trading within the fund tends to generate fewer capital gains distributions to shareholders.

Balanced funds

Balanced funds strike a balance between stocks and bonds. A typical allocation for a balanced fund is 60/40, which translates to 60% allocated to stocks and 40% to fixed income and cash. Balanced funds offer investors an opportunity to invest in an “all in one” type of mutual fund.

The Vanguard Balanced Index Inv fund (ticker VBINX) is a balanced fund that strives to maintain a 60/40 allocation. The fund is also an index fund that tracks both a U.S. stock index and total U.S. bond index in proportion to that 60/40 target.

International and global funds

There are a number of mutual funds that invest in stocks and bonds of companies and governments based outside of the United States. These funds offer diversification away from U.S.-based investments.

International mutual funds may invest in stocks or bonds issued by companies or governments of developed market countries or emerging markets countries. Developed markets include countries like Canada, France, Germany, and the United Kingdom. Major emerging market countries include China, Brazil, South Africa, and India. International investing offers diversification away from investing solely in U.S. stocks and bonds.

Global mutual funds will hold securities both from the United States and from non-U.S. markets. These funds offer worldwide diversification to investors.

Target date funds

Target date funds are offered by a number of mutual fund providers, including Vanguard, T. Rowe Price, Fidelity, and American Funds, among others. Target date funds are usually funds of mutual funds offered by parent mutual fund companies. TDFs are a common offering in 401(k) plans as they are geared to a target retirement date.

Target date funds will decrease their allocation to stocks over time as they get closer to the target date of the fund. At some point the TDFs will go into its glide path where the equity allocation levels off into retirement.

According to Kiplinger, the top four target date fund families in 2023 were American Funds, Blackrock, Fidelity, and John Hancock. These fund families represent the best combination of cost, a “to” glidepath, and aggressiveness based on evaluation by this forecaster.

Sector and specialty funds

Sector funds are mutual funds that focus on a particular industry or sector of the economy. For example, Vanguard Energy Inv fund (ticker VGENX) focuses on stocks in the energy and utility sectors. Top holdings as of January 16, 2024, included Shell PLC and ConocoPhillips.

An example of a specialty fund would be one of the many Environmental, Social, and Governance (ESG) focused funds that have sprung up in recent years. The Vanguard Global ESG Select Stock Fund Investor Shares (ticker VEIGX) is an actively managed fund that holds a global portfolio of mid to large-cap stocks that adhere to a high standard of ESG practices.

Money market funds

A money market mutual fund typically holds cash and short-term, highly liquid debt securities. Money market funds will typically maintain a net asset value of $1 per share, with any interest earned going towards increasing the underlying value of the investor’s account.

Money market funds are often used as cash accounts for investors. This acts as the settlement account in a brokerage or IRA account for distributions that are not reinvested or for the proceeds of the sale of a security in the account.

Mutual fund fees

Virtually all mutual funds have an expense ratio. This is how the mutual fund covers the costs of running the mutual fund. These include the cost of trading securities owned by the fund as well as other expenses such as the salaries of the fund manager and other staffers on the fund.

The expense ratio is published on the mutual fund’s website, in fund documents such as the fund prospectus, and on third-party sites such as Morningstar. The expense ratio is paid as a reduction of the net return that fund shareholders receive.

For example, if a mutual fund has an annual expense ratio of 0.50% and the fund’s gross return from its investments is 10% for the year, then the net return that would be earned by shareholders is 9.5%. This is a simplistic illustration as these calculations are done on a daily basis and there could be other types of fees that serve to reduce your net return.

A common type of fee that is part of the expense ratio is a 12b-1 fee. This was originally deemed to be a fee to cover marketing expenses for mutual funds that charge them, but for many fund companies, the 12b-1 fee has become a way to add to their revenue and/or to compensate registered reps and brokers for selling their funds.

Another type of fee is a sales load. This is a fee that is charged upfront on some mutual funds at the time of purchase. There are also back-end loads that are charged if a shareholder tries to sell their shares prior to the passage of a set period of time. Back-end loads may decrease over a period of several years until they reach zero.

The American Funds Class A fund (ticker AMCPX) is a large cap growth fund. This share class of the fund charges an upfront sales load of 5.75%. This means that on a $1,000 fund purchase, only $943.50 of your money is invested, with $57.50 going to the fund company as a sales charge.

Before investing in any mutual fund, it is important that investors understand all fees and expenses associated with the fund. Overpaying in terms of fees and expenses can detract from your overall investment returns.

Classes of mutual fund shares

There are a number of different mutual fund share classes and structures.

While technically not a share class, mutual funds that have no upfront or backend sales load are known as “no load funds.” No load funds can still have relatively high expenses and may charge a 12b-1 fee as part of their expense ratio.

There is a version of the no load fund that is known as clean shares. These funds have no sales loads and also do not charge 12b-1 fees.

Class A shares typically impose a front-end sales charge on purchases. This sales charge may be reduced or eliminated for purchases above a specified dollar threshold or if the fund purchases are made on a frequent or regular basis. Class A shares will often have a 12b-1 fee connected to them as well.

Class B shares do not charge an upfront sales load but rather impose a backend load, which is a contingent deferred sales charge. This means that your entire investment is put to work in the fund. The backend load is usually a declining percentage over a set period of time. You would incur this charge if you sold some or all of your shares prior to the end of this period.

Class B shares also typically impose a 12b-1 fee that is generally higher than for most other share classes. Class B shares are designed to keep investors from selling their holdings so that the fund company can continue to collect their fund expenses, which are usually on the higher side for this share class.

Thankfully, Class B shares are largely a thing of the past, and few, if any, mutual fund families still issue new Class B shares.

Class C shares also impose no upfront sales charge. They typically charge a redemption fee, 1% is common, within the first year if you were to sell some or all of the shares. Class C shares typically have higher expense ratios, including 12b-1 fees, than Class A shares do. Class C shares cannot be converted to Class A shares, so you are stuck with these higher expenses for as long as you own them.

Even within the no-load fund umbrella, there may be different share classes. For example, low-cost fund provider Vanguard offers an investor share class, an admiral share class, and in some cases, an institutional share class. The differences are in the minimum investment required and the expense ratios of the funds. The investor share class will tend to have the lowest investment minimum and the highest expense ratio. Otherwise, the underlying portfolios are the same.

Advantages of mutual funds

Mutual funds offer investors a number of advantages.

• Mutual funds are professionally managed. An individual investor does not have to pick individual stocks and bonds on their own.
• Mutual funds offer a level of diversification within the fund portfolio. Even if all of the securities in the fund are of a similar type, the fund will hold a variety of different stocks and bonds. Using mutual funds to implement your overall investing strategy makes it easy to diversify among several asset classes to achieve overall portfolio diversification.
• Economies of scale. By investing through mutual funds, an investor doesn’t have to deal with transaction costs on individual securities. A diversified portfolio of individual stocks and bonds could be very costly in terms of transaction costs to purchase all of these individual securities. This could be especially true for a small investor who is only buying a few shares of each holding.
• Many mutual funds offer a low minimum investment, making it easy for a small investor to invest in a diversified portfolio of mutual funds across the full spectrum of asset classes.

Disadvantages of mutual funds

Mutual funds also have some disadvantages.

• Some funds saddle investors with high fees, front or back-end sales loads, and other charges that can really eat into your returns.
• Mutual fund managers may be forced to hold a pool of cash to meet investor redemption requests. This can be a drag on the fund’s returns.
• Some actively managed funds can experience style drift away from their normal investment objective. The manager may vary the fund’s holdings in a fashion that deviates from the fund’s normal investment style in order to boost returns. This can make adhering to an asset allocation strategy difficult for fund investors.
• Mutual funds can generate unwanted taxable capital gains for investors holding funds in a taxable account based on the sales of underlying holdings in the fund by the fund manager.
• There is a lack of transparency inside the holdings of a mutual fund. Unlike exchange-traded funds (ETFs), mutual funds are only required to report their holdings at periodic intervals and not on a daily basis.

How to buy a mutual fund

There are a number of options available to investors who want to buy mutual funds.

Brokerage firms such as TD Ameritrade and its parent company, Charles Schwab, offer a large selection of mutual funds from a wide range of mutual fund families, including Schwab’s own funds. Other major firms, including Fidelity Investments and Vanguard, offer a vast selection of funds.

Mutual funds can be purchased inside of an individual retirement account (IRA) as well as through a taxable brokerage account. Some mutual fund companies, like T. Rowe Price, Fidelity, and Vanguard, also offer accounts that allow for investments in not only their mutual funds, but in other types of investments.

Some mutual fund companies allow investors the ability to automatically invest a set amount in a fund at regular intervals. This can be an excellent way for investors to get started with investing and to build wealth over time.

ETFs vs. mutual funds

ETFs and mutual funds are similar in many respects. However, ETFs are traded in real-time on a stock exchange, whereas mutual funds only trade at the end of each trading day.

Like mutual funds, ETFs are professionally managed and invest in stocks and bonds based on the fund’s stated objective. ETFs do tend to be lower-cost and more tax-efficient. This is likely in large part due to the fact that many ETFs are index funds.

In the case of Vanguard, their ETFs are run as another share class of their corresponding mutual funds. An example is their Vanguard 500 index fund or their Vanguard Total Stock Market Index fund.