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What is a Mutual Fund?

Kathleen ChaykowskiJuly 2, 2019
Covered finance and business at Forbes and The Wall Street Journal. BA, Stanford University.
definition

Mutual funds give people a way to invest in a diverse mix of stocks, bonds, or other securities by buying shares of a larger pool that’s managed by a professional.

This is for illustrative purposes only and does not constitute investment advice. Actual allocations of a mutual fund will vary.

🤔 Understanding mutual funds

Mutual Funds are professionally managed pools that allow people to easily invest in a mishmash of securities, like stocks and bonds. Most of the time, they’re focused on stocks (aka, equities), but they can also come in different flavors, with a focus on bonds, foreign equities, or even risk levels. They’re managed by professional investors, who decide where to invest the pool, and they’ve become a popular destination in company-sponsored retirement plans, where workers place their hard-earned dollars. But their convenience isn’t free: Mutual funds come in different share classes with different fees and expenses. The potential risk and rewards of mutual funds are discussed in each fund’s prospectus.

Takeaway

Buying a share in a mutual fund is kind of like getting a scoop of fruit salad…

Everyone who owns a share in a mutual fund gets the same mix of investments, whether that’s stocks, bonds, or cash — every scoop has the same proportion of ingredients. As the value of the fund as a whole rises or falls in value, each person’s investment fluctuates with it.

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Tell me more...

How is owning a mutual fund share different from owning a stock?
Why are mutual funds so common?
How much does it cost to invest in a mutual fund?
How do people make money from mutual funds?
What are some of the trade-offs of mutual funds?
How many types of mutual funds are there?
How are mutual funds different from ETFs?

How is owning a mutual fund share different from owning a stock?

Owning a share of a mutual fund is different from owning a single stock in six main ways:

  1. The goods: A share of a mutual fund is made up of investments in many different stocks or other securities, while a share of a stock is just that stock.
  2. Control: People don’t get to control how the mutual fund manages its money — just whether or not they put money in the pool. Meanwhile, people purchasing individual stocks can decide to buy or sell that stock any time.
  3. Fluctuations: Gains or losses from investing in a mutual fund reflect the performance of every component of the mutual fund combined, while, gains or losses from a stock depend solely on the movement of that stock.
  4. Tradeability: Open-end mutual fund shares aren’t tradeable during the day. Their price doesn’t change during market hours, and instead, gets settled at the end of each trading day. Stocks, however, can be traded anytime through the trading day.
  5. Voting rights: People who invest in mutual funds don’t have any voting rights over the underlying securities, while stock owners can have the opportunity to get this sway.
  6. Pricing: Stock prices are determined through open market trading, while the cost of a mutual fund share (known as net asset value (NAV) is found by subtracting the liabilities of the fund (aka expenses) from the total value of each component of the fund and dividing that value by the total number of shares in that fund — kind of like calculating the cost of a single scoop of fruit salad, served from a giant bowl. When the overall value of the fund increases in value, the fund’s price per share typically rises. And when the value of the fund shrinks, its price per share, and the value of the investment to shareholders, falls.

Why are mutual funds so common?

A couple aspects of mutual funds are pretty appealing to many people:

  1. Easy to use: They’re managed by someone else. They’re run by a professional investor who decides how the fund trades and picks its strategy. As noted earlier, this comes with a fee, which can affect how much a shareholder gains from his or her investment.
  2. Variety: Mutual funds come in tons of flavors, so there’s a good chance that if you’re looking for one focused on a category of stocks or geography, that you’ll be able to find one that covers your interests.
  3. Diversification: They can be an easy way for people to help manage the risk of their investments. The typical mutual fund holds hundreds of different stocks, bonds, and securities. By distributing the fund across so many different types of investments, each individual shareholder in the fund doesn’t have extreme exposure to any single security, which may help cushion against sudden drops that might affect a particular asset. Keep in mind though that diversifying doesn’t ensure a profit or protect against a loss when you invest in a mutual fund.
  4. Access: Sometimes mutual fund managers have access to buying certain stocks or securities that the nonprofessional investor might not have the ability to buy. Buying shares in a mutual fund can let you indirectly own these securities.

How much does it cost to invest in a mutual fund?

In some ways, mutual funds operate much like a company. There’s someone managing the fund, known as a fund manager, or investment adviser, whose job is to make the best investment decisions on behalf of the pool’s shareholders. These fund managers might also hire analysts to help them research the market and make investment decisions.

These expenses mean that mutual funds almost always come at a cost to the investor, regardless of whether they put a huge or small amount into the pool. This cost is often a fee charged on an ongoing basis that takes a percentage of how much you’ve invested in the fund. If a mutual fund has a 0.5% fee, called an expense ratio, the shareholder pays $5 per year for every $1,000 invested. Typically the fund doesn’t send a bill in the mail — they’ll deduct it from the assets of the fund. These expense ratios can typically range anywhere from less than 0.1% to more than 3%.

Class A shares: But, not every share within a fund comes with the same type and amount of fees. Funds can be made up of many different groups of shares, known as “classes,” which have different fee structures. Class A shares, for example, typically charge a sales fee from the get go, that gets deducted from your initial investment. However, they tend to have a lower yearly expense ratio than our next group, Class B. Class A shares might also have a 12b-1 fee (an annual fee that covers the costs of marketing and selling fund shares), although this fee would generally be lower than the 12b-1 fee for certain other classes.

Class B shares: Class B shares tend not to have an upfront fee, but do usually trigger a fee when you sell your shares in the fund a certain number of years after purchasing those shares. This is called a back-end or deferred sales charge, and often applies if an investor sells their shares within five to eight years. Fund managers also don’t typically adjust those costs even if you buy a lot of shares. As a result, this group can be appealing to investors who may not have a lot of cash to invest right now, but who plan to keep their money invested for a long time. Over time, Class B shares can be converted to Class A shares, but until that happens, you’re like to have higher yearly fees associated with owning Class B’s.

Class C shares: Meanwhile, Class C shares might have a 12b-1 fee and a deferred sales charge or upfront fee, but the deferred sales charge or upfront fee is usually lower than Class B’s deferred sales charge or Class A’s upfront fee. Class C can have some advantages for people who might not be investing in a fund for a long period of time. These shares usually only charge additional sales fees for selling shares if investors withdraw from the pool within the first year.

The Prospectus: It’s important to know how much funds charge in fees when deciding whether or not to invest. Keep in mind, managers typically charge a fee even if the fund loses money. More information about a fund’s fees and expenses can be found in a legal document called a “prospectus.” You can get a fund’s prospectus by contacting the mutual fund or the financial professional selling the fund. Read the prospectus carefully before investing -- it’s packed with critical info in what you’re about to put your money into.

How do people make money from mutual funds?

Investors in mutual funds can receive their money back by redeeming their shares from the fund. The fund itself that invests the money earns a return in two primary ways as the underlying investments rise in value or fall, increasing or decreasing the price of the fund’s shares:

  1. Distribution: Stocks in the fund’s portfolio may return quarterly dividends or bonds may send out interest payments back to shareholders (that’s the fund, in this case). Fund managers will often reinvest these distributions in an attempt to increase the value of the fund.
  2. Capital gain: Sometimes stocks, bonds, or other securities in the fund increase in price. When this happens, the fund might sell those securities and make a gain, which is classified as a capital gain and may be invested further by the fund manager.

What are some of the trade-offs of mutual funds?

Mutual funds come with a lot of perks, but they have their limitations and downsides. Here are some key ones:

  1. Fees: Like we mentioned, mutual funds usually don’t come free. The fees vary based on the type of fund based on how it’s managed (more or less actively) or even the share class within the fund (whether fees are when you buy in or sell out). Reading the prospectus of each fund is critical to ensure you know what fees to expect.
  2. Fluctuation: There’s no guarantee that a mutual fund will make money for you (aka generate a return on your investment) or that the mutual fund will perform better than a selection of stocks and securities that you choose yourself. But, they do have a track record, which can be a helpful signal in determining whether or not they could be a good place to park some of your investment dollars. Mutual funds are actually required to show you their performances in the prospectus for periods of time, such as one or five-year performances.
  3. They’re “sit-down,” not “to-go”: Unlike stocks, open-end mutual fund shares can’t be traded during the day, because they get priced at the end of the day. Unlike Exchange Traded Funds (ETFs) that are more “to-go,” mutual funds are more like “sit-down” acai bowls. ETFs tend to be relatively more “liquid” than open-end mutual funds because of this ability to trade during the day.
  4. Taxes: When customers redeem their shares in a fund and they’ve increased in value, they’re taxable as capital gains (because you’ve gained money on the investment).

How many types of mutual funds are there?

Mutual funds are often focused on stocks, but there are plenty of other varieties. There are mutual funds for almost every type of investment, whether that’s bonds, foreign equities, or investments focused on specific slices of the mark, or risk levels. Funds can also be built around what’s known as the “target date” -- the time by which the investors in the pool are planning to retire, and access any gains from the pool.

Funds fall into two primary categories, that explain when and where people can buy or sell their shares:

  1. Closed-end funds: These funds raise money through an initial public offering, like a company going public might, and then list their shares on an exchange. Closed-end funds tend to be actively managed, and their portfolios often focus on a specific geography or industry. People can trade these shares during the trading day, like they could do with a regular stock.
  2. Open-end funds: These are the most common type of funds. Instead of offering their shares in a public offering, open-end funds let investors redeem their shares directly through the fund for both buying and selling.

Despite the variety that’s out there, many mutual funds tend to have one thing in common: diversification. The average fund holds hundreds of securities with the goal of giving investors exposure to a variety of different investments .

How are mutual funds different from ETFs?

Like mutual funds, ETFs are made up of a smoothie-like mix of securities, which can help an investor manage their overall risk. However, these types of investments have two major differences:

  1. Different fees: As a whole, ETFs aren’t actively managed as often as mutual funds are (although, actively-managed ETFs do exist). Most ETFs are what’s called passively managed, which means they involve less manual trading work, and are likely tied to a market index. As a result, the fees that come with ETFs are typically lower than the fees associated with mutual funds.
  2. Taxes: Gains from ETFs and mutual funds are often taxed differently, so it’s helpful to know how returns from a specific fund could be taxed before deciding to invest. In some cases, ETFs can offer tax advantages that may help reduce how much capital gains tax a shareholder pays. Knowing the tax efficiency is key before making an investment.
  3. Trading flexibility: ETFs can be bought and sold through the trading day, while open-end mutual funds can only be purchased at the end of the trading day when the mutual fund price is determined.

Robinhood Financial LLC does not offer mutual funds. For more information about mutual funds and ETFs, see the SEC’s Guide for Investors. 20190617-875554-2639814

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