Mutual Funds Explained: A Simple Guide to Mutual Funds

A mutual fund is a professionally managed investment portfolio of stocks, bonds, securities, and other assets that are collectively funded by a pool of investors. Mutual fund investors don't actually own any of the underlying investments purchased by the mutual fund company, but all of the investors equally share any gains or losses earned by the fund. Every mutual fund has a prospectus that describes the fund's specific investment objectives and determines the type of individual securities that the manager will include in the fund's portfolio. The goal of the fund manager is to allocate the fund's assets into a diversified portfolio that generates profit for its investors in the form of dividends or capital gains. The primary reasons to invest in a mutual fund include: 1. __Diversification__: Mutual funds let you build a diverse portfolio without the hassle of purchasing a large number of individual stocks in separate transactions. Mutual funds can include a wide array of industries and asset classes. 2. __Risk customization__: Based on your financial goals and other factors such as your age, you can choose a mutual fund that matches your desired risk tolerance. For example, younger investors may be willing to take on riskier investments since they have time to earn back losses caused by short-term market volatility. 3. __Professional management__: A knowledgeable fund manager monitors all the securities in a mutual fund's portfolio. Depending on market conditions, the fund manager adjusts the fund's investments in order to help achieve the fund's financial goals. Since this is a portfolio manager's full-time job, individual investors aren't burdened with making their own investing decisions. There are numerous types of mutual funds available to investors, all regulated by the US Securities and Exchange Commission (SEC), including: 1. __Stock funds__: Also called equity funds, stock funds consist primarily of stocks as opposed to other types of securities. Stock funds are typically categorized based on the size of the companies the fund invests in (i.e., small-cap, mid-cap, or large-cap) and the investment approach (i.e., value funds or growth funds). A fund's market cap value is determined by multiplying its share price by its total number of shares outstanding. 2. __Bond funds__: This type of mutual fund contains investments that pay a fixed return rate, such as corporate bonds, government bonds, certificates of deposit (CDs), and high-yield bonds. Since they pay a fixed return, bond funds are also called fixed-income funds. When bond fund investments reach their maturity date, investors receive their principal investment back on top of the fixed interest already received. If market interest rates go up, the value of the bond fund decreases since investors are locked in at the lower interest rate. 3. __Hybrid funds__: Also called asset allocation funds or balanced funds, hybrid funds diversify risk across a mix of different asset classes. Hybrid funds typically invest in both stocks and bonds, and they may also include investments in commodities or money market instruments. 4. __Index funds__: Rather than attempt to beat the market, the goal of an index fund is to simply match one of the primary market indexes, like the Dow Jones Industrial Average, S&P 500, or the NASDAQ Composite index, as part of a long-term investment strategy. 5. __Target-date funds__: Investors in a target-date fund choose a year to meet their investment goal (often their intended retirement year) and the fund's asset allocation automatically adjusts as the target date approaches. Early on, the fund contains a riskier asset allocation to encourage growth, and as the fund's target date nears, its asset allocation becomes more conservative since there is less time to make up potential losses. Target-date funds sometimes serve as a long-term investment option for those without a workplace retirement plan since you can invest in a target-date fund through an IRA (individual retirement account). 6. __Money market funds__: This type of mutual fund invests in short-term debt securities with high liquidity, such as U.S. Treasury bills. Money market funds are low-risk and low-return. Money market funds can be a useful option for investors who need a place to store money before making other investments. The common types of mutual fund fees include: - __Sales loads__: These are one-time commissions some mutual fund companies charge when you buy a mutual fund (a front-end load) or sell a mutual fund (a back-end load). No-load mutual funds allow you to avoid these sales charges. - __Redemption fees__: A mutual fund may charge a redemption fee if you sell fund shares that you've only owned for a pre-specified short period of time. - __Expense ratio__: The expense ratio is an annual fee every investor must pay to cover the mutual fund's operating expenses, which includes any administration and management fees. The expense ratio is typically between one and three percent. - __Transaction fees__: Some brokerages charge investors transaction fees whenever the investor buys or sells mutual fund shares. Transaction fees are a flat dollar amount no matter the size of the trade, and investors must pay the fee every time they buy or sell shares. [Exchange-traded](https://www.masterclass.com/articles/what-is-an-etf) funds and mutual funds are both collections of multiple securities, but there are key differences. - __Trading time__: ETFs allow for intraday trading, meaning that just like stocks, ETF share prices fluctuate throughout the day, and you can buy or sell ETFs through your brokerage account at the value of the current market price. Mutual funds do not allow intraday trading, meaning that you can only buy or sell mutual funds for the price set after the market closes for the day, known as the net asset value or NAV. - __Tax-efficiency__: ETFs are typically more tax-efficient than mutual funds. This is because mutual funds, especially actively managed ones, trade more often and result in more capital gains taxes than ETF investing. - __Fees__: Similar to stock investing, you might pay brokerage commissions for ETF investing, but ETFs have fewer fees than mutual funds. On average, expense ratios (the annual fee charged to investors to cover a fund's administrative expenses) are much lower for ETFs than mutual funds. - __Management structures__: ETFs are usually, but not always, passively managed funds that aim to match the performance of a specific stock index, while a fund manager manages a mutual fund with the goal of outperforming a stock index (with the exception of index funds). All investments and investment strategies entail inherent risks and introduce the potential for financial loss or the depreciation of assets. The information presented in this article is for educational, informational, and referential purposes only. Consult a professional investment advisor before making any financial commitments. Get the [MasterClass Annual Membership](https://www.masterclass.com) for exclusive access to video lessons taught by business luminaries, including Bob Iger, Chris Voss, Robin Roberts, Sara Blakely, Daniel Pink, Howard Schultz, Anna Wintour, and more. Learn about the different types of mutual funds and how they can contribute to a diverse stock portfolio.