Mutual Funds: Benefits, Types and How They Work
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What are mutual funds?
Mutual funds are a type of investment that pools together money from many investors, then uses that money to invest in stocks, bonds or other assets.
Mutual funds are typically managed by a professional who selects the investments for the fund.
There are mutual funds to suit most investment styles and goals.
Mutual fund investors don’t directly own the stock or other investments held by the fund, but they do share equally in the profits or losses of the fund’s total holdings — hence the “mutual” in mutual funds.
Index funds and exchange-traded funds are similar to mutual funds in that they hold a number of different assets within a single investment.
Benefits of mutual funds
Simplicity: Once you find a mutual fund with a good record, you have a relatively small role to play: The fund managers do all the heavy lifting of selecting and rebalancing investments.
Low costs: Investing costs have come down, and that extends to mutual funds. Mutual funds can be an inexpensive way to hold many investments at once. Passive funds like index funds and ETFs are even more cost-effective.
Diversification: Mutual funds provide access to a large selection of investments without the difficulties of having to purchase and monitor dozens of individual assets yourself.
How mutual funds work
No matter which category a mutual fund falls into, its fees and performance will depend on whether it is actively or passively managed. Passively managed funds invest according to a set strategy. They try to match the performance of a specific market index, and therefore require little investment skill or professional management. Given that, they will carry lower fees than actively managed funds.
Actively managed funds have a fund manager or team making decisions about how to invest the fund's money, so they typically charge higher fees. Often they try to outperform the market or a benchmark index, but studies have shown passive investing strategies often deliver better returns.
How mutual funds earn a return
When you invest in a mutual fund, your investment or the fund's value can increase from three sources:
Dividend payments: When a fund receives dividends or interest on the securities in its portfolio, it distributes a proportional amount of that income to its investors. When purchasing shares in a mutual fund, you can choose to receive your distributions directly, or have them reinvested in the fund.
Capital gain: When a fund sells a security that has gone up in price, this is a capital gain. (And when a fund sells a security that has gone down in price, this is a capital loss.) Most funds distribute any net capital gains to investors annually.
Net asset value (NAV): As the value of the fund increases, so does the price to purchase shares in the fund (known as the NAV per share). This is similar to when the price of a stock increases — you don’t receive immediate distributions, but the value of your investment is greater, and you would make money should you decide to sell.
Keep in mind that as with any investment, you can also lose money, especially in the short-term.
Common types of mutual funds
The 3-mutual fund portfolio
Building a portfolio with mutual funds
Building the best investment portfolio for you can be challenging. There are lots of mutual funds out there — how do you know which is the best? With just three types of mutual funds, you can build a well-diversified portfolio quickly based on your time horizon and risk tolerance. NerdWallet's Marko Zlatic walks through all the details in this video.
