What is a Mutual Fund?

Mutual funds pool money from several investors and then build a portfolio containing bonds, stocks, and other securities. They can offer excellent diversification with professional management, which makes a nice choice for a lot of investors.

In essence, mutual funds are financial firms that sell shares to investors, only to then invest those proceeds in securities such as bonds, stocks, short-term debt, derivatives, etc. All of these holdings, which can be composed of hundreds of securities, help make up the portfolio of the mutual fund, then.

Professional investors allocate a great amount of their time simply picking bonds and stocks to generate a well-balanced investment portfolio. It can be a challenging task, requiring plenty of research and expertise to be good at. Mutual funds can make such expert management accessible to regular investors, all for some reasonable fees, of course. If you are saving for your retirement in an individual retirement account, i.e., IRA, or a 401(k), you might already have a couple of mutual funds in your possession. According to a study conducted by the Investment Company Institute in 2021, around 45% of US households owned mutual funds.

How Do Mutual Funds Work?

For investors, every mutual fund share represents partial ownership of that fund. If those funds experience any profits or losses, they're shared with every investor in the fund.

Mutual funds may receive dividends or interest from their holdings. Depending on what type of fund it is, fund managers can opt to either share the profits with investors or reinvest them. If the fund incurs losses, then that is also shared.

Choices that other investors make may affect the performance of the fund. If mutual fund holders want to sell the shares they own, fund managers might need to liquidate a few of that fund's holdings to render them whole. However, if a lot of investors sell at the same time or around then, it can suffer losses.

Mutual funds are also different from other securities when it comes to fees, net asset value, and management styles.

Net Asset Value and Mutual Funds

Net asset value here represents the total assets within a mutual fund, i.e., all the securities and cash inside the fund's portfolio minus all the debt and liabilities. The answer is then divided by the amount of outstanding shares.

Unlike individual stocks, with prices fluctuating minute by minute, the NAV for mutual funds is only calculated once each day, at every trading session's end at the close of the market.
NAV may even be regarded as the closing price of the fund since every order to purchase and sell a mutual fund tends to be executed at the price found at the trading day's end.

What are Mutual Fund Fees?

Mutual funds may have various fees. But the most common type would be the expense ratio, which is an annual fee that investors are charged with that covers the fund's running expenses. This fee is typically expressed as a percentage of the investment. For instance, having a 0.5% expense ratio implies that 0.5% of one's investment will go to the operating costs of the fund instead of creating more returns. This is why you should pick investments that have lower investment ratios. If a mutual fund is reliant on active management, which just means that you have managers who are the ones actively making decisions regarding what securities to purchase and sell in attempts to beat the underlying benchmark, then no doubt the expense ratio would be greater. At the same time, if you're dealing with passively managed funds, which just mirror the underlying benchmark index, then you'll likely have lower expense ratios, with some even as low as zero.

Mutual funds may also come with sales loads or sales charges. These happen to be one-time fees that you pay when purchasing the fund or selling the fund, i.e., a front-end or back-end sales load, respectively. Not every mutual fund has sales loads, so it would be best if you avoided these whenever possible by just investing in no-load mutual funds. Then there are 12b-1 fees too, which are simply marketing fees acquired from the assets of the fund. These cover the expenses associated with marketing and selling those funds. You might want to avoid these as well.

How to Choose a Mutual Fund?

If you possess a retirement account with your employer, like a 401(k), then you might already own some mutual funds or have access to them at least. If you do not, then you may open brokerage accounts and invest within mutual funds with your conventional IRA, or individual retirement accounts, or other prominent investment accounts. But how would you go about deciding what mutual funds to buy? Here is what to look for. When comparing different mutual funds, there are some key factors you'd want to note, like management style, fees, past performance, and investment objectives, the first two of which we’ve already discussed.

Investment Objectives

Investment objectives here would be what the fund is exactly trying to accomplish. For instance, a few funds seek to make income, while others tend to concentrate on capital preservation and growth. So, see if it aligns with what you think will make the fund a worthwhile investment.

Past Performance

While a mutual fund's performance in the past is not indicative of any future success, it could still grant you a clue of how that fund has performed over time relative to market indices.

Conclusion

Mutual funds have proven to be a great investment vehicle for several kinds of investors since they're easy to use and can be great for diversification. Many employer-sponsored retirement plans, such as the 401(k)s, utilize mutual funds, so you might already own a couple of them. So, if you are just starting your investing journey, mutual funds can be one of the best ways to go about it. You may create a diversified portfolio with only a single mutual fund, though more may certainly be better.