What Does a Mutual Fund Do?

Are you looking to strike it rich in the stock market? You shouldn’t listen to your buddy at work who swears by buying shares in a startup he claims will be “the next Amazon.” There’s a much safer way to go about building your wealth — and it goes by the name “mutual fund.” Read our comprehensive guide to learn everything about this innovative investment vehicle and how it might fit into your portfolio.

What is a mutual fund and how does it work?

Before we get into details about investing in mutual funds and how mutual funds work, you may be wondering, What is a mutual fund? (You may also see me call them MFs for short). 

If you don’t work in the investing world or didn’t grow up exposed to it, a term like this may baffle you.

However, you should definitely take the time to familiarize yourself with what they are and how mutual funds work. Mutual funds can generate some serious profits for your portfolio over the long term, so you don’t want to miss out.

Picture a mutual fund as a community potluck. It’s basically a pool of money that many investors contribute to. A mutual fund uses investors’ money to buy assets like stocks, bonds, and money market funds. Check out TD Ameritrade’s explanation here: 

When it comes to different kinds of risk levels, mutual funds lie right in the middle of the spectrum. They allow for more capital appreciation than CDs and government bonds, but they don’t have the volatility of futures and options.

Before they become available to the public, all mutual funds have to register with the SEC, or the Securities and Exchange Commission. However, you should note that the FDIC (Federal Deposit Insurance Corporation) doesn’t insure mutual funds at all.

Now that we’ve covered the basics, you might still be wondering, How do mutual funds make me money?

There isn’t just one way it generates you money. Rather, there are several things going on that can increase your wealth:

• Selling securities: Your MF may sell securities during the year to make a profit, which investors call a capital gain. Once it accounts for capital losses, it’ll distribute the net profit to shareholders at the close of the year.
• Paying dividends: If a mutual fund includes dividend-paying assets, you’ll receive a portion of companies’ earnings via dividends. You can keep these dividends in your pocket or reinvest them back into the MF.
• Holding securities: Sometimes, a fund won’t sell its securities. Rather, it hangs onto them in profitable times. When a mutual fund’s portfolio increases in value, your shares’ market value will also likely increase. The only difference — these capital gains are “on paper” rather than directly in your wallet.

What does a mutual fund do differently than other investments?

Mutual funds are popular in the United States and have two distinct features that set them apart from other types of investments:

• Share classes: We divide MFs into three classes — A, B, and C. These classes differ in fees, discounts, and minimum amounts, so there’s something to meet everyone’s needs.
• Professional management: Almost always, MFs are managed by professional advisors who decide which assets the fund will invest in. Nothing’s ever left up to chance. These professionals use their industry expertise to make sound financial decisions for their shareholders.

What are the different types of mutual funds?

Wait a second — there isn’t just one type of mutual fund?

If this panicked thought just crossed your mind, you aren’t alone. Learning that there are different types can be quite overwhelming at first. However, they aren’t too difficult to understand.

In fact, knowing the different types can help you more efficiently reach your goals. Explore your options below:

Stock fund

As you could probably guess, stock funds invest primarily in stocks, which are also called equity funds. Stock funds aren’t for the faint of heart. These MFs tend to frequently rise and fall because of fluctuating stock prices.

You’ll have to be comfortable watching your account drop by several hundred dollars (even thousands) in a day, only to watch it rise back up several weeks later.

Stock funds tend to perform better over the long term. This pattern persists because, historically, stocks tend to rise and outperform other types of investments.

You are also different flavors of stock funds. For example, growth funds will invest in more growth stocks, while income funds might invest in a more stable business that pays a dividend.

Money market fund

Money market funds are relatively low-risk. They mostly invest in short-term investments that are deemed safer. Examples of these include government entities and U.S.-based corporations.

Bond fund

Bond funds mostly invest in different types of bond purchases. They present more risk than money market mutual funds, but they often result in higher returns. They pay a steady rate of return like high-yield corporate bonds and government bonds. 

Bond funds’ primary goal is to have money come into the fund consistently. Most of this money comes from interest that the fund earns.

Balanced fund

Balanced funds, also called asset allocation funds, are fixed combinations of bond funds, stock funds, and money market mutual funds. They offer the ideal mixture of modest capital appreciation, income, and safety. Their asset allocations remain mostly fixed, so you don’t have to worry about abrupt fluctuations.

Target-date fund

Do you like to keep your eye on the retirement prize? Target-date funds (sometimes called lifecycle funds) were designed for you. This investment program has a specific end date in mind by which you can hit retirement or other major life event.

While it’s usually targeted for retirement dates, this date may also be when you anticipate needing money for a big life event. Want to send your kids to college when they graduate high school in the 2040s? Target-date funds will be your best friend.

Target-date funds (or many also call them retirement date funds) contain a healthy mix of stocks, bonds, and other securities. The balance of these securities changes overtime to keep up with the growth you’re hoping to achieve.

Specialty fund

If you don’t want to throw your money into a cause you don’t believe in, look into specialty funds. These investments focus on specialized categories like certain commodities or real estate. Some of them prioritize the environment, diversity, human rights, and social responsibility in their investments.

Some mutual fund investors appreciate how certain specialty funds avoid investing in companies that deal with weapons, alcohol, gambling, or tobacco. These might be called sector funds, if they invest in a single sector for example.

Specialty funds are an excellent way to invest in stocks ethically, so you can feel good about where you’re putting your money.

The pros & cons of mutual funds

As with any major financial decision, adding MFs to your portfolio will come with pros and cons.

From our experience, the pros tend to outweigh the cons. But, to give you the fullest picture possible, we’ll cover both. Read on to learn more.

Pros

There are plenty of reasons to get behind MFs, and we’ll explore them more in-depth below:

1. Higher liquidity

Tying up your money in an investment can be scary. What if you need quick access to your portfolio funds in case of an emergency?

An MF is relatively liquid compared to other types of investments. You can sell your shares on any business day. Then, you’ll receive access to your cash within seven business days.

You won’t have to wait weeks or months for your cash to arrive in your bank account, which will give you the peace of mind you deserve.

2. Professional management

Even if you’re several years into adulthood, investing in mutual funds may still seem like a foreign concept to you.

And that’s perfectly okay. You’re not alone.

Mutual funds were designed to help individuals who are clueless about investing. All the management takes place by a qualified investment professional (referred to as the portfolio manager). You can choose passively- or actively-managed funds.

Passively managed ones don’t try to outperform the stock market. Instead, they try to mimic the market to produce excellent long-term results.

When you invest in an actively-managed fund, an investment professional will research different investment vehicles (such as stocks), decide which investments to make, and monitor the fund’s performance over time.

No matter which type of management you choose, you won’t have to get involved. You can sit back and watch your money work for you.

3. Low minimums

Did you know that some investment vehicles like hedge funds can require a minimum amount of $100,000 or more to get started?

Oftentimes, we picture investors as multimillionaires with plenty of dollar bills to carelessly throw around. Obnoxious minimum startups may not be a big deal to these guys, as they have a lot of money to spare.

For us more frugal folk, investing doesn’t have to cost a lot of money.

Thankfully, mutual funds come with incredibly low startup fees. You can often get started for as little as $500 or $1,000.

Even if this is a week’s paycheck for you, this amount will go a long way when you invest it for twenty or more years.

4. More opportunity for growth

If you have savings set aside, you shouldn’t let them sit under your bed in cold hard cash. Cash depreciates when it’s not in an investment account, so you should transition it to a place where it can grow.

Checking accounts, savings accounts, and CDs can offer interest rates, but these rates aren’t even enough to keep up with inflation. Currently, the average interest rate for savings accounts in the U.S. is only 0.04% APY.

If you put $1,000 into a savings account that has a .04% APY and make no additional contributions, you’ll only have $1,002 at the end of 5 years. This extra $2 can’t even buy you a cheap lunch.

As an alternative, you can try putting your money into an MF. In the long run, you’ll experience a much higher rate of return (often around 10%) than the conservative accounts you’ve been relying on.

5. Dividend reinvestment

Oftentimes, an MF supplies you dividends — payments to shareholders when companies make a profit.  

What are you supposed to do with these dividends? Fund your morning cup of Joe?

While some investors pocket their dividends, it’s much wiser to reinvest them back into your mutual fund.

As the companies in your MF declare dividends and other types of interest income, you can opt to reinvest them. This strategy will build on your investment objectives and increase your net worth over time.

And if you’re investing for retirement, this can help you reach those goals a lot quicker.

Cons

To be fair, no investment vehicle is perfect. 

Mutual funds have some potential cons that you should be aware of before making your investment:

1. They’re not FDIC-insured

Mutual funds aren’t FDIC-insured. Other investment vehicles also aren’t backed by this agency, so it may not seem like a big deal.

However, if your MF performs poorly, you may lose a big portion of the money you invest. In rare circumstances, some MF investors in the past have lost all their money because of the lack of FDIC insurance.

2. Multiple transaction fees

Most MFs come with several fees or sales charges, including an expense ratio and commissions. You can learn more about the specific shareholder fees in the next section.

It’ll cost some money to make money, so don’t allow these fees to intimidate you.

3. Capital gains tax

If your MF makes a capital gains distribution, you may have to pay a hefty capital gains tax of up to 20%.

4. Less control over your investments

While you can pick which MF you put your money into, that’s about where your freedom ends. The fund manager decides where your (and your fellow shareholders’) money goes.

If where your money ends up is important to you, be sure to pick an MF that prioritizes sustainable and responsible investing.

What are the fees associated with mutual funds?

As you may have realized at this point in your life, nothing is ever free. Mutual funds are no exception. Therefore, understanding fees tied to mutual funds is important.

When you invest in mutual funds, expect to pay some fees. These fees shouldn’t discourage you from investing. They’re a natural part of the investing process, so you’ll have to take them in stride. However, you shouldn’t settle for any mutual fund and willingly pay them the fees they’re asking for you. Before you start throwing your money at an MF, you need to understand the fees involved.

Check out some fees you can expect:

• Account maintenance fee: This monthly or annual fee lets you use the brokerage firm and its accompanying research tools. Many brokerages will make this fee tiered. When you pay a higher account maintenance fee, you’ll gain access to more detailed data and analytic tools.
• 12b-1 fee: The 12b-what-now? This fee is a mutual fund’s annual marketing fee. In order to grow, your mutual fund has to attract new investors somehow. So, it may charge all current investors a small fee to cover its advertising costs. This fee will never be more than 1% of your fund’s total assets, so you don’t have to worry about it eating up your profits. However, you should look for an MF with as low of a 12b-1 fee as possible. Every bit counts, so be sure to save where you can.
• Expense ratio: The mutual fund’s fund managers have to get their cut for running the fund, and that’s exactly what the expense ratio is.
• Redemption fee: As victorious as this fee sounds, it’s not one you ever want to incur. It comes up if you sell your shares within a short period after buying them. Some mutual funds’ redemption fees will become irrelevant after a couple of days or weeks. Others keep their redemption fees in place for well up to a year.
• Commissions (also referred to as sales loads): Commissions are quite common, and they can add up fast if you’re not careful. Commissions apply when you buy or sell shares. Commissions aren’t punitive like redemption fees, but they’ll still come out of your pocket.
• Exchange fees: Not happy with how your current fund is performing? It may cost you to transfer your shares over to another fund within the same investment company.
• Other expenses: Believe it or not, we didn’t cover all the mutual fund fees out there. These investment vehicles, depending on their fund manager, may come with other fees. These fees include legal, custodial, transfer agent, accounting, and other administrative costs.

Some fees, like the expense ratio, are inevitable. However, some mutual funds come with excessively high fees that you can avoid by going with a different fund.

Know all the fees involved before you start shoveling your money into your investment of choice. You’ll want to be with your vehicle for the long haul, so make sure you find one with minimal fees.

How to choose the right mutual fund

All types of investing come with risk. This includes the mutual fund.

However, you can lower your risk by searching for one wisely.

Follow these tips to reduce your risk and help you sleep a little more soundly at night:

1. Look at the history: Don’t narrow your focus to how a mutual fund has performed over the last year or two. It can be enticing to hop on board to one that’s had excellent success in recent years. However, your best bet is to go with a mutual fund that has experienced long-term success. Be sure to look at the big picture. Ideally, you should analyze its performance over the last decade or two.
2. Compare similar mutual funds: For a minute, we’re going to ask you to forget the “don’t compare yourself to others” advice. When it comes to mutual funds, you want to invest in one that performs well to similar funds. Ideally, it should be neck-and-neck with a good benchmark like the Russell 2000 Index or the S&P 500. Note that if you want to just track an index, an index fund might be a good option to consider.
3. Diversify: Don’t toss all your savings into one mutual fund. Just like with other types of investment vehicles, diversification is key with mutual funds. Arguably, mutual funds are already diversified. They’re made up of assets from various companies, so they come with some level of built-in diversification. However, you can diversify even more by spreading your money into different types of mutual funds, like growth/income, growth, aggressive growth, and international ones.

As you start to look for a mutual fund, we’ll leave you with a final piece of advice — diversification isn’t an immediate fix to a lousy performance.

Even if you have the most balanced and diversified of investment portfolios, your investing journey won’t always be positive. You’ll have some good days, and you’ll have some bad days.

However, we encourage you to be an emotionless investor. Don’t allow your feelings to get the best of you and cause you to panic sell. If you stick with it, you’ll see excellent rewards in the long run.

FAQs

How do you make money from a mutual fund?

You make money from a mutual fund when the individual stocks within the fund increase in value. This, in turn, improves the net asset value (NAV) of the mutual fund, thus driving an increased dollar amount per share, and thus netting you a gain overall.

Can you get rich from mutual funds?

It is possible to get rich from mutual funds, depending on how you look at it. As long as the net asset value (NAV) of your funds are going up over time, so will your returns. But there are also other factors with mutual funds.

For example, there is a money manager (fund manager) as well as several investment advisers (typically) who help decide the strategy of the fund, as well as any corresponding management fees. Take this into account when buying a mutual fund.

What happens when you buy a mutual fund?

When you buy a MF, you’ll become part owner of the fund itself – depending on how many shares you buy (think of it like being part of a big family). These funds invest in a variety of different securities for a certain management fee. You’re paying for the services of the company that runs the fund, as well as embedded investment advice, but this type of investment is relatively hands-off. Then, when the NAV – net asset value – of the fund increases, you earn a return.

Are mutual funds good for a retirement account?

Yes, mutual funds can be an excellent option for a retirement account. In fact, the company you work for likely offers mutual funds within your 401(k) account. Just be aware of the fees charged for the services done on the fund (i.e., managing it) and talk to your company if they don’t offer funds that fit your needs or if you need further advice.

Does my credit score play a role in investing?

Not really. Even if you have terrible credit, many brokerages will allow you to invest since you’re putting up collateral to buy the security. That being said, there tends to be a positive correlation of credit score and net worth, so it’s a good idea to improve your credit as you start investing more.

What are index funds?

Index funds are like a mutual fund, only they are passively managed (or have no management at all) and are designed to track or follow a certain index – such as the S&P 500. Fees are much lower for index funds, and many investors like the ease of just following an index instead of someone’s investment strategy.

Conclusion — are mutual funds right for you?

Mutual funds are steady investment vehicles. According to Statista, there have been at least 7,500 mutual funds in the U.S. since 2000. These vehicles have survived several financial crises, including the 2008 housing crisis and the 2020 recession. While they don’t carry the exciting risks that riskier investments do, MFs are profitable vehicles that offer security.

If you’re new to the investing world, consider adding mutual funds to your fund portfolio. You can use these to meet any financial goals you have, whether you hope to buy a home or fund your kiddos’ college. Even if you don’t have a specific goal in mind, they’re great ways to build your wealth. Just be careful as you choose a mutual fund to invest in. Some come with unnecessarily high fees or have histories of poor management.

Whatever one you pick should have a trustworthy history. Although past performance is no guarantee of future performance, it’s a good signal to look for. If you have more short-term investing goals, we recommend you steer clear of MFs. Selling your shares too quickly can result in higher fees and taxes.

However, anyone with long-goals can greatly benefit from a mutual fund when they play their cards right. Talk to your investment advisor about getting into mutual funds today!