A mutual fund is an investment option where money from many people is pooled together to buy a variety of stocks, bonds, or other securities. This mix of investments is managed by a professional money manager, providing individuals with a portfolio that is structured to match the investment objectives stated in the fund’s prospectus.

By investing in a mutual fund, individuals gain access to a broad range of investments, which can help reduce risk compared to investing in a single stock or bond. Investors earn returns based on the fund’s performance minus any fees or expenses charged. In this way, mutual funds can give small or individual investors access to professionally managed portfolios of equities, bonds, and other asset classes.

Understanding Mutual Funds

A mutual fund is a type of investment that pools money from many people to invest in a variety of assets like stocks, bonds, or other securities. This pooling allows individuals to diversify their investments and access a broader range of strategies or assets than they might be able to on their own.

A mutual fund effectively owns a portfolio of investments that is funded by all the investors who have purchased shares in the fund. So when an individual buys into a mutual fund, they gain part-ownership of all the underlying assets that fund owns. This gives the individual investor exposure to a much wider swath of the market through a single mutual fund investment compared to what they might be able to buy individually.

The performance of the mutual fund depends on the underlying assets that it holds. If these assets increase in value on net, so does the value of the fund’s shares. Conversely, if the assets decrease in value, so does the value of the shares.

The fund manager oversees the portfolio, making decisions about how to allocate money across sectors, industries, companies etc. based on the stated strategy of the fund. By pooling money into a large fund, investors can participate in a professionally-managed, diversified group of securities that they wouldn’t usually have access to as individuals. This diversification and access is a key benefit of mutual funds for individual investors.

Types of Mutual Funds

There are several types of mutual funds available for investment, though most mutual funds fall into one of four main categories which include stock funds, money market funds, bond funds, and target-date funds.

Stock Funds

As the name implies, this fund invests principally in equity or stocks. Within this group are various subcategories. Some equity funds are named for the size of the companies they invest in: small-, mid-, or large-cap. Others are named by their investment approach: aggressive growth, income-oriented, value, and others. Equity funds are also categorized by whether they invest in domestic (U.S.) stocks or foreign equities. To understand the universe of equity funds is to use a style box, an example of which is below.4

Funds can be classified based on both the size of the companies, their market caps, and the growth prospects of the invested stocks. The term value fund refers to a style of investing that looks for high-quality, low-growth companies that are out of favor with the market. These companies are characterized by low price-to-earnings (P/E) ratios, low price-to-book (P/B) ratios, and dividend yields. Conversely, growth funds look to companies with strong earnings, sales, and cash flow growth. These companies typically have high P/E ratios and do not pay dividends. A compromise between strict value and growth investment is a “blend,” which refers to companies that are neither value nor growth stocks and are classified as somewhere in the middle.

Large-cap companies have high market capitalizations, with values over $10 billion. Market cap is derived by multiplying the share price by the number of shares outstanding. Large-cap stocks are typically blue-chip firms that are often recognizable by name. Small-cap stocks refer to those with a market cap ranging from $250 million to $2 billion. These smaller companies tend to be newer, riskier investments. Mid-cap stocks fill in the gap between small- and large-cap.5

A mutual fund may blend its strategy between investment style and company size. For example, a large-cap value fund would look to large-cap companies that are in strong financial shape but have recently seen their share prices fall and would be placed in the upper left quadrant of the style box (large and value). The opposite of this would be a fund that invests in startup technology companies with excellent growth prospects: small-cap growth. Such a mutual fund would reside in the bottom right quadrant (small and growth).

Bond Funds

A mutual fund that generates a minimum return is part of the fixed income category. A fixed-income mutual fund focuses on investments that pay a set rate of return, such as government bonds, corporate bonds, or other debt instruments. The fund portfolio generates interest income that is passed on to the shareholders.

Sometimes referred to as bond funds, these funds are often actively managed and seek to buy relatively undervalued bonds to sell them at a profit. These mutual funds will likely pay higher returns but aren’t without risk. For example, a fund specializing in high-yield junk bonds is much riskier than a fund that invests in government securities.

Because there are many different types of bonds, bond funds can vary dramatically depending on where they invest, and all bond funds are subject to interest rate risk.

Index Funds

Index funds invest in stocks that correspond with a major market index such as the S&P 500 or the Dow Jones Industrial Average (DJIA). This strategy requires less research from analysts and advisors, so fewer expenses are passed on to shareholders, and these funds are often designed with cost-sensitive investors in mind.

Balanced Funds

Balanced funds invest in a hybrid of asset classes, whether stocks, bonds, money market instruments, or alternative investments. The objective of this fund, known as an asset allocation fund, is to reduce the risk of exposure across asset classes.

Some funds are defined with a specific allocation strategy that is fixed, so the investor can have a predictable exposure to various asset classes. Other funds follow a strategy for dynamic allocation percentages to meet various investor objectives. This may include responding to market conditions, business cycle changes, or the changing phases of the investor’s own life.

The portfolio manager is commonly given the freedom to switch the ratio of asset classes as needed to maintain the integrity of the fund’s stated strategy.

Money Market Funds

The money market consists of safe, risk-free, short-term debt instruments, mostly government Treasury bills. An investor will not earn substantial returns, but the principal is guaranteed. A typical return is a little more than the amount earned in a regular checking or savings account and a little less than the average certificate of deposit (CD).

Income Funds

Income funds are named for their purpose: to provide current income on a steady basis. These funds invest primarily in government and high-quality corporate debt, holding these bonds until maturity to provide interest streams. While fund holdings may appreciate, the primary objective of these funds is to provide steady cash flow​ to investors. As such, the audience for these funds consists of conservative investors and retirees.

International/Global Funds

An international fund, or foreign fund, invests only in assets located outside an investor’s home country. Global funds, however, can invest anywhere around the world. Their volatility often depends on the unique country’s economy and political risks. However, these funds can be part of a well-balanced portfolio by increasing diversification, since the returns in foreign countries may be uncorrelated with returns at home.

Specialty Funds

Sector funds are targeted strategy funds aimed at specific sectors of the economy, such as financial, technology, or healthcare. Sector funds can be extremely volatile since the stocks in a given sector tend to be highly correlated with each other.

Regional funds make it easier to focus on a specific geographic area of the world. This can mean focusing on a broader region or an individual country.

Socially responsible funds, or ethical funds, invest only in companies that meet the criteria of certain guidelines or beliefs. For example, some socially responsible funds do not invest in “sin” industries such as tobacco, alcoholic beverages, weapons, or nuclear power. Other funds invest primarily in green technology, such as solar and wind power or recycling.

Mutual Fund Fees

A mutual fund has annual operating fees or shareholder fees. Annual fund operating fees are an annual percentage of the funds under management, usually from about 1–3%, known as the expense ratio. A fund’s expense ratio is the summation of the advisory or management fee and its administrative costs.

Shareholder fees are sales charges, commissions, and redemption fees paid directly by investors when purchasing or selling the funds. Sales charges or commissions are “the load” of a mutual fund. When a mutual fund has a front-end load, fees are assessed when shares are purchased. For a back-end load, mutual fund fees are assessed when investors sell their shares.

Sometimes, however, an investment company offers a no-load mutual fund, which doesn’t carry any commission or sales charge. These funds are distributed directly by an investment company, rather than through a secondary party. Some funds also charge fees and penalties for early withdrawals or selling the holding before a specific time has elapsed.

How to Invest in Mutual Funds

Today, investing in mutual funds is a fairly straightforward process that involves the following steps:

1. Make sure you have a brokerage account with enough cash on hand, and with access to mutual fund shares.
2. Identify specific mutual funds that match your investing goals in terms of risk, returns, fees, and minimum investments. Many platforms offer fund screening and research tools.
3. Determine how much you want to invest initially and submit your trade. If you choose, you can often set up automatic recurring investments as desired.
4. Monitor and review performances periodically, making adjustments as needed.
5. When it is time to close your position, enter a sell order on your platform.

Pros and Cons of Mutual Fund Investing

There are a variety of reasons that mutual funds have been the retail investor’s vehicle of choice, with an overwhelming majority of money in employer-sponsored retirement plans invested in mutual funds.

Pros

• Liquidity
• Diversification
• Minimal investment requirements
• Professional management
• Variety of offerings

Cons

• High fees, commissions, and other expenses
• Large cash presence in portfolios
• No FDIC coverage
• Difficulty in comparing funds
• Lack of transparency in holdings

Example of a Mutual Fund

One of the most notable mutual funds is Fidelity Investments’ Magellan Fund (FMAGX). Established in 1963, the fund had an investment objective of capital appreciation via investment in common stocks.12 The fund’s height of success was between 1977 and 1990 when Peter Lynch served as its portfolio manager. Under Lynch’s tenure, Magellan’s assets under management increased from $18 million to $14 billion.13

Fidelity’s performance continued strong, and assets under management (AUM) grew to nearly $110 billion in 2000. By 1997, the fund had become so large that Fidelity closed it to new investors and would not reopen it until 2008.14

As of March 2022, Fidelity Magellan has nearly $28 billion in assets and has been managed by Sammy Simnegar since Feb. 2019.12 The fund’s performance has tracked or slightly surpassed that of the S&P 500.

The Bottom Line

Mutual funds are a versatile and accessible investment option for individuals looking to diversify their portfolios. These funds pool money from various investors to purchase a broad array of assets like stocks, bonds, or other securities, managed by professional money managers. The key benefits include access to diversified, professionally managed portfolios and a range of investment categories tailored to different objectives and risk tolerances. However, mutual funds come with fees and expenses, including annual fees, expense ratios, or commissions, which can impact overall returns.