What Are Mutual Funds and How Do They Work?

What Are Mutual Funds?

A mutual fund is a type of investment that allows you, along with thousands of other investors, to invest in dozens or even hundreds of different securities, making it easy to diversify your portfolio.

Mutual funds are managed by professional portfolio managers who make investment decisions on behalf of the fund's investors. Each fund typically has a set of objectives, such as income, growth or capital preservation.

Mutual funds are popular investments because they're accessible and require minimal effort to achieve diversification. They can also give investors access to a wide range of assets, industries and strategies.

Learn more: How to Start Investing

How Do Mutual Funds Work?

A mutual fund raises money from investors so it can invest in different securities, with a goal of offering investors a return on their money based on the fund's stated objective.

When you buy mutual fund shares, you are purchasing an ownership piece of the fund's portfolio. Your shares entitle you to a share of the fund's earnings, which can come in the form of dividends, interest or capital gains.

Mutual funds are managed by professionals who make decisions about which securities to buy and sell based on the fund's strategy. The value of your investment will fluctuate based on the performance of the fund's underlying assets. This value is reflected by the fund's net asset value (NAV), which is calculated at the end of each trading day.

Although mutual funds are generally used as part of a long-term investing strategy, you can convert your investment into cash if you need to by selling your shares at the current NAV.

Actively Managed vs. Passively Managed Mutual Funds

Mutual funds generally fall under two umbrellas: actively managed and passively managed. Each approach has its benefits and drawbacks, so knowing which type you're investing in can help you make smarter, more informed decisions about your portfolio.

Here's a quick summary of each option:

• Actively managed mutual funds: Active funds are controlled by fund managers who buy and sell fund holdings with the goal of beating the fund's targeted benchmark, such as the S&P 500. These funds tend to have higher administrative fees than passively managed funds because managers are more involved in making ongoing strategic decisions.
• Passively managed funds: Passive funds, such as index funds, usually track a specific index and try to mirror the return of that index. Because fund managers play less of a hands-on role in picking investments, passively managed funds tend to have lower management fees.

While active funds typically cost more, the potential for beating the market can be worth it for some investors. In 2024, 42% of active funds beat their passive counterparts, according to Morningstar.

Learn more: What Is a Stock Market Index?

Types of Mutual Funds

Depending on your investment strategy, there are several mutual funds from which you can choose to achieve your objectives. Here's a look at some of the most common types of mutual funds.

Bond Funds

Bond funds invest in fixed-income debt securities, which are essentially loans from investors to corporations and government entities. The fund pools your money with other investments to buy a diversified collection of bonds.

Bond funds can also vary in risk depending on the types of bonds they hold. For example, government bonds are generally safer, while corporate or high-yield bonds carry more risk but may provide higher returns.

Stock Funds

Stock funds invest in corporate stocks, which represent partial ownership—or equity—in those companies. These funds aim to grow your portfolio through capital appreciation and, in some cases, dividend income paid by the underlying stock holdings.

Stock funds come in many forms, each with different strategies and risk levels. For example, some may focus on fast-growing companies (growth funds), specific industries (sector funds) or stocks from companies based outside the U.S. (international funds).

Because stock prices can fluctuate significantly, these funds generally carry more risk than bond funds, but they also offer greater potential for long-term growth.

Index Funds

As previously mentioned, index funds aim to mimic the return of a benchmark stock index, such as the S&P 500 or the Nasdaq-100. As passive funds, they tend to charge low fees. However, they also don't offer the chance to beat the benchmark index.

Money Market Funds

Money market funds invest in short-term debts that have high liquidity. They usually include U.S. Treasuries and certificates of deposit (CDs) and carry relatively low risk.

Money market funds are ideal for investors nearing or in retirement who want to preserve as much of their capital as possible. However, they tend to offer lower returns than other fund types.

Balanced Funds

Balanced funds, or asset allocation funds, invest in a mix of assets to reduce risk but still provide potential for growth and income. They typically stick to a fixed allocation of stocks and bonds.

The greater the percentage of the fund's money that's invested in stocks, the riskier the fund will be.

Target-Date Funds

​​Target-date funds, also called lifecycle funds, are also mixed bags that may invest in stocks, bonds and other securities. Regardless of the makeup, the fund's pool of money is invested with a target date in mind.

Asset allocation is chosen based on the time until retirement or other goal, with risk lessening as the target date approaches.

Learn more: Types of Investment Accounts

ETF vs. Mutual Fund

Exchange-traded funds (ETFs) work similarly to mutual funds in that they pool money from investors to create a diversified portfolio of stocks, bonds or other assets.

The primary difference is that ETFs are traded on stock exchanges, so their prices fluctuate in real time rather than just once a day. This can make them more preferable for investors who want to buy or sell their shares in a fund at any point during market hours. Here's more about how the two options differ.

Learn more: Pros and Cons of Investing in ETFs

Mutual Fund Fees

There are generally two types of fees you'll see in a mutual fund: shareholder fees and operating expense ratio. Here's what to know about each type of mutual fund fee.

Shareholder Fees

Shareholder fees are based on your individual investment choices and activity in the fund. Here's what you can expect:

• Load fee: A commission charged when you buy (front-end load) or sell (back-end load) shares in certain mutual funds. These fees often range from 2% to 5% and are paid to brokers or advisors.
• Exchange fee: This fee is charged when you move money between different funds within the same mutual fund family.
• Redemption fee: You may be charged this fee if you sell your shares of the fund within a certain timeframe after purchasing them. The timeline can vary depending on the type of fund, with some setting limits of 30, 180 or 365 days. The maximum fee is 2% and goes directly to the fund.
• Purchase fee: You may be charged this fee in addition to a front-end load to offset trading costs. The fee goes to the fund rather than a broker or advisor.
• Account fee: Some funds may charge a recurring fee if your account balance falls below a certain threshold.

Operating Expense Ratio

A mutual fund's expense ratio covers the annual operating costs of managing the portfolio. The asset-weighted average expense ratio for all mutual funds and ETFs was 0.34% in 2024, according to Morningstar. Active funds charge an average of 0.59%, while passive funds charge an average of 0.11%.

Here's a breakdown of the costs that contribute to the expense ratio:

• Management fee: Paid to the fund's portfolio manager and their team for making investment decisions. This is typically the largest component of the expense ratio.
• 12b-1 fee: Covers marketing, advertising and sometimes distribution or shareholder services. It's legally capped at 1% per year, though many funds charge less.
• Administrative expenses: This may include recordkeeping, customer support, compliance and reporting services needed to operate the fund.

Pros and Cons of Mutual Funds

As with any investment, it's important to carefully weigh both the advantages and disadvantages that come with mutual funds. Here's what to keep in mind.

Should I Invest in Mutual Funds?

Mutual funds can be a smart option for many investors, but whether they're right for you depends on your goals and preferences. Here are some key factors to consider:

• Your investment experience: Mutual funds are great for beginners or anyone who prefers a hands-off investing approach. Professional fund managers handle all the buying and selling decisions.
• Diversification needs: If you want broad exposure to different asset classes without picking individual stocks or bonds, mutual funds offer instant diversification with a single investment.
• Your time commitment: Mutual funds are ideal for long-term investors who don't want to actively manage their portfolio.
• Access to retirement accounts: Mutual funds are commonly used in 401(k)s, individual retirement accounts (IRAs) and other retirement plans, making them easy to integrate into your long-term savings strategy.
• Trading preferences: Mutual funds only trade once per day after markets close. If you want more control over trading times or prefer intraday flexibility, an ETF might be a better fit.
• Fee sensitivity: While some mutual funds are low-cost, others may come with higher expense ratios or sales charges. Always compare fees before investing.

If these factors align with your needs, mutual funds could be a strong addition to your investment portfolio.

Learn more: What's the Difference Between Saving and Investing?

How to Invest in Mutual Funds

The process of buying mutual funds is pretty straightforward, and much of it can be done online. You'll need to open an investment account, fund it and purchase shares. Here's a more in-depth breakdown of the process:

1. Choose where to invest. You can buy funds directly from fund management companies or through brokerage firms.
2. Open an account. After choosing where you'll invest, the next step is opening an investment account. The application to open an account usually involves entering your name, address and Social Security number and filling out an investment profile.
3. Transfer funds into the account. You'll be asked to transfer money into the account to invest. Usually, you can connect your bank account to move cash, but other options could be setting up a wire transfer or mailing a check.
4. Choose mutual funds to purchase. Search for a mutual fund's name or symbol and enter how much you want to invest. Before buying a mutual fund, you should review its performance and read through its prospectus, which outlines the fund's goals and objectives.

Learn more: How to Pick a Mutual Fund

The Bottom Line

Investing in mutual funds can be a great way to diversify your portfolio, but be sure to review costs carefully. Expense ratios might seem like a small percentage, but they can eat away at your investment earnings over time.

Also, pay close attention to the investment goals of each fund. If you invest in funds with similar holdings, the overlap could be risky if a certain sector or company takes a hit. Speaking with a financial advisor can help you iron out an investing strategy that makes sense for your goals and risk tolerance.