What Is a Mutual Fund?

A mutual fund is a type of financial vehicle made up of a pool of money collected

from many investors to invest in securities like stocks, bonds, money market
instruments, and other assets. Mutual funds are operated by professional money
managers, who allocate the fund's assets and attempt to produce capital gains or
income for the fund's investors. A mutual fund's portfolio is structured and
maintained to match the investment objectives stated in its prospectus.

Mutual funds give small or individual investors access to professionally managed

portfolios of equities, bonds, and other securities. Each shareholder, therefore,
participates proportionally in the gains or losses of the fund. Mutual funds invest
in a vast number of securities, and performance is usually tracked as the change
in the total market cap of the fund—derived by the aggregating performance of
the underlying investments.

KEY TAKEAWAYS

 A mutual fund is a type of investment vehicle consisting of a portfolio of

stocks, bonds, or other securities.
 Mutual funds give small or individual investors access to diversified,
professionally managed portfolios at a low price.
 Mutual funds are divided into several kinds of categories, representing the
kinds of securities they invest in, their investment objectives, and the type
of returns they seek.
 Mutual funds charge annual fees (called expense ratios) and, in some
cases, commissions, which can affect their overall returns.
 The overwhelming majority of money in employer-sponsored retirement
plans goes into mutual funds.

Understanding Mutual Funds

Mutual funds pool money from the investing public and use that money to buy
other securities, usually stocks and bonds. The value of the mutual fund
company depends on the performance of the securities it decides to buy. So,
when you buy a unit or share of a mutual fund, you are buying the performance
of its portfolio or, more precisely, a part of the portfolio's value. Investing in a
share of a mutual fund is different from investing in shares of stock. Unlike stock,
mutual fund shares do not give its holders any voting rights. A share of a mutual
fund represents investments in many different stocks (or other securities) instead
of just one holding.
That's why the price of a mutual fund share is referred to as the net asset value
(NAV) per share, sometimes expressed as NAVPS. A fund's NAV is derived by
dividing the total value of the securities in the portfolio by the total amount of
shares outstanding. Outstanding shares are those held by all shareholders,
institutional investors, and company officers or insiders. Mutual fund shares can
typically be purchased or redeemed as needed at the fund's current NAV, which
—unlike a stock price—doesn't fluctuate during market hours, but it is settled at
the end of each trading day. Ergo, the price of a mutual fund is
also updated when the NAVPS is settled.

The average mutual fund holds over a hundred different securities, which means
mutual fund shareholders gain important diversification at a low price. Consider
an investor who buys only Google stock before the company has a bad quarter.
He stands to lose a great deal of value because all of his dollars are tied to one
company. On the other hand, a different investor may buy shares of a mutual
fund that happens to own some Google stock. When Google has a bad quarter,
she loses significantly less because Google is just a small part of the fund's
portfolio.

How Mutual Funds Work

A mutual fund is both an investment and an actual company. This dual nature
may seem strange, but it is no different from how a share of AAPL is a
representation of Apple Inc. When an investor buys Apple stock, he is buying
partial ownership of the company and its assets. Similarly, a mutual fund investor
is buying partial ownership of the mutual fund company and its assets. The
difference is that Apple is in the business of making innovative devices and
tablets, while a mutual fund company is in the business of making investments.

Investors typically earn a return from a mutual fund in three ways:

1. Income is earned from dividends on stocks and interest on bonds held in

the fund's portfolio. A fund pays out nearly all of the income it receives over
the year to fund owners in the form of a distribution. Funds often give
investors a choice either to receive a check for distributions or to reinvest
the earnings and get more shares.
2. If the fund sells securities that have increased in price, the fund has
a capital gain. Most funds also pass on these gains to investors in a
distribution.
3. If fund holdings increase in price but are not sold by the fund manager, the
fund's shares increase in price. You can then sell your mutual fund shares
for a profit in the market.
If a mutual fund is construed as a virtual company, its CEO is the fund manager,
sometimes called its investment adviser. The fund manager is hired by a board of
directors and is legally obligated to work in the best interest of mutual fund
shareholders. Most fund managers are also owners of the fund. There are very
few other employees in a mutual fund company. The investment adviser or fund
manager may employ some analysts to help pick investments or perform market
research. A fund accountant is kept on staff to calculate the fund's NAV, the daily
value of the portfolio that determines if share prices go up or down. Mutual funds
need to have a compliance officer or two, and probably an attorney, to keep up
with government regulations.

Most mutual funds are part of a much larger investment company; the biggest
have hundreds of separate mutual funds. Some of these fund companies are
names familiar to the general public, such as Fidelity Investments, The Vanguard
Group, T. Rowe Price, and Oppenheimer.

Types of Mutual Funds

Mutual funds are divided into several kinds of categories, representing the kinds
of securities they have targeted for their portfolios and the type of returns they
seek. There is a fund for nearly every type of investor or investment approach.
Other common types of mutual funds include money market funds, sector funds,
alternative funds, smart-beta funds, target-date funds, and even funds of funds,
or mutual funds that buy shares of other mutual funds.

Equity Funds
The largest category is that of equity or stock funds. As the name implies, this
sort of fund invests principally in 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. There are so many different types of equity funds because there are
many different types of equities. A great way to understand the universe of equity
funds is to use a style box, an example of which is below.

The idea here is to classify funds based on both the size of the companies
invested in (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 high dividend yields. Conversely, spectrums are growth funds, which look to
companies that have had (and are expected to have) strong growth in earnings,
sales, and cash flows. 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 simply refers to companies that are neither value nor growth
stocks and are classified as being somewhere in the middle.

The other dimension of the style box has to do with the size of the companies
that a mutual fund invests in. 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 stocks with a market cap ranging from $300 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.

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).

Fixed-Income Funds
Another big group is 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 idea is that the fund portfolio
generates interest income, which it then passes on to the shareholders.

Sometimes referred to as bond funds, these funds are often actively

managed and seek to buy relatively undervalued bonds in order to sell them at a
profit. These mutual funds are likely to pay higher returns than certificates of
deposit and money market investments, but bond funds aren't without risk.
Because there are many different types of bonds, bond funds can vary
dramatically depending on where they invest. For example, a fund specializing in
high-yield junk bonds is much riskier than a fund that invests in government
securities. Furthermore, nearly all bond funds are subject to interest rate risk,
which means that if rates go up, the value of the fund goes down.

Index Funds
Another group, which has become extremely popular in the last few years, falls
under the moniker "index funds." Their investment strategy is based on the belief
that it is very hard, and often expensive, to try to beat the market
consistently. So, the index fund manager buys 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 there
are fewer expenses to eat up returns before they are passed on to shareholders.
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 is to reduce
the risk of exposure across asset classes.This kind of fund is also known as an
asset allocation fund. There are two variations of such funds designed to cater to
the investors objectives.

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.

While the objectives are similar to those of a balanced fund, dynamic allocation
funds do not have to hold a specified percentage of any asset class. The portfolio
manager is therefore given 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. This is a safe place to park your money. You
won't get substantial returns, but you won't have to worry about losing your
principal. A typical return is a little more than the amount you would earn in a
regular checking or savings account and a little less than the average certificate
of deposit (CD). While money market funds invest in ultra-safe assets, during the
2008 financial crisis, some money market funds did experience losses after the
share price of these funds, typically pegged at $1, fell below that level and broke
the buck.

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 in order to provide interest streams.
While fund holdings may appreciate in value, 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. Because they produce regular
income, tax-conscious investors may want to avoid these funds.

International/Global Funds
An international fund (or foreign fund) invests only in assets located outside your
home country. Global funds, meanwhile, can invest anywhere around the world,
including within your home country. It's tough to classify these funds as either
riskier or safer than domestic investments, but they have tended to be more
volatile and have unique country and political risks. On the flip side, they can, as
part of a well-balanced portfolio, actually reduce risk by increasing diversification,
since the returns in foreign countries may be uncorrelated with returns at home.
Although the world's economies are becoming more interrelated, it is still likely
that another economy somewhere is outperforming the economy of your home
country.

Specialty Funds
This classification of mutual funds is more of an all-encompassing category that
consists of funds that have proved to be popular but don't necessarily belong to
the more rigid categories we've described so far. These types of mutual funds
forgo broad diversification to concentrate on a certain segment of the economy or
a targeted strategy. Sector funds are targeted strategy funds aimed at specific
sectors of the economy, such as financial, technology, health, and so on. Sector
funds can, therefore, be extremely volatile since the stocks in a given sector tend
to be highly correlated with each other. There is a greater possibility for large
gains, but a sector may also collapse (for example, the financial sector in 2008
and 2009).

Regional funds make it easier to focus on a specific geographic area of the

world. This can mean focusing on a broader region (say Latin America) or an
individual country (for example, only Brazil). An advantage of these funds is that
they make it easier to buy stock in foreign countries, which can otherwise be
difficult and expensive. Just like for sector funds, you have to accept the high risk
of loss, which occurs if the region goes into a bad recession.

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. The idea is to get competitive
performance while still maintaining a healthy conscience. Other such funds invest
primarily in green technology, such as solar and wind power or recycling.

Exchange Traded Funds (ETFs)

A twist on the mutual fund is the exchange traded fund (ETF). These ever more
popular investment vehicles pool investments and employ strategies consistent
with mutual funds, but they are structured as investment trusts that are traded on
stock exchanges and have the added benefits of the features of stocks. For
example, ETFs can be bought and sold at any point throughout the trading day.
ETFs can also be sold short or purchased on margin. ETFs also typically carry
lower fees than the equivalent mutual fund. Many ETFs also benefit from
active options markets, where investors can hedge or leverage their positions.
ETFs also enjoy tax advantages from mutual funds. Compared to mutual funds,
ETFs tend to be more cost effective and more liquid. The popularity of ETFs
speaks to their versatility and convenience.

Mutual Fund Fees

A mutual fund will classify expenses into either annual operating fees or
shareholder fees. Annual fund operating fees are an annual percentage of the
funds under management, usually ranging from 1–3%. Annual operating fees are
collectively 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, which come in the form of sales charges, commissions, and
redemption fees, are paid directly by investors when purchasing or selling the
funds. Sales charges or commissions are known as "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 an
investor sells his 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. Also, the rise of exchange-traded
funds, which have much lower fees thanks to their passive management
structure, have been giving mutual funds considerable competition for investors'
dollars. Articles from financial media outlets regarding how fund expense ratios
and loads can eat into rates of return have also stirred negative feelings about
mutual funds.

Classes of Mutual Fund Shares

Mutual fund shares come in several classes. Their differences reflect the number
and size of fees associated with them.

Currently, most individual investors purchase mutual funds with A shares through
a broker. This purchase includes a front-end load of up to 5% or more, plus
management fees and ongoing fees for distributions, also known as 12b-1 fees.
To top it off, loads on A shares vary quite a bit, which can create a conflict of
interest. Financial advisors selling these products may encourage clients to buy
higher-load offerings to bring in bigger commissions for themselves. With front-
end funds, the investor pays these expenses as they buy into the fund.

To remedy these problems and meet fiduciary-rule standards, investment

companies have started designating new share classes, including "level load" C
shares, which generally don't have a front-end load but carry a 1% 12b-1 annual
distribution fee.

Funds that charge management and other fees when an investor sell their
holdings are classified as Class B shares.

A New Class of Fund Shares

The newest share class, developed in 2016, consists of clean shares. Clean
shares do not have front-end sales loads or annual 12b-1 fees for fund services.
American Funds, Janus, and MFS are all fund companies currently offering clean
shares.

By standardizing fees and loads, the new classes enhance transparency for
mutual fund investors and, of course, save them money. For example, an
investor who rolls $10,000 into an individual retirement account (IRA) with a
clean-share fund could earn nearly $1,800 more over a 30-year period as
compared to an average A-share fund, according to an April 2017 Morningstar
report co-written by Aron Szapiro, Morningstar director of policy research, and
Paul Ellenbogen, head of global regulatory solutions.2

Advantages of Mutual Funds

There are a variety of reasons that mutual funds have been the retail investor's
vehicle of choice for decades. The overwhelming majority of money in employer-
sponsored retirement plans goes into mutual funds. Multiple mergers have
equated to mutual funds over time.

Diversification
Diversification, or the mixing of investments and assets within a portfolio to
reduce risk, is one of the advantages of investing in mutual funds. Experts
advocate diversification as a way of enhancing a portfolio's returns, while
reducing its risk. Buying individual company stocks and offsetting them with
industrial sector stocks, for example, offers some diversification. However, a truly
diversified portfolio has securities with different capitalizations and industries and
bonds with varying maturities and issuers. Buying a mutual fund can achieve
diversification cheaper and faster than by buying individual securities. Large
mutual funds typically own hundreds of different stocks in many different
industries. It wouldn't be practical for an investor to build this kind of a portfolio
with a small amount of money.
Easy Access
Trading on the major stock exchanges, mutual funds can be bought and sold with
relative ease, making them highly liquid investments. Also, when it comes to
certain types of assets, like foreign equities or exotic commodities, mutual funds
are often the most feasible way—in fact, sometimes the only way—for individual
investors to participate.

Economies of Scale
Mutual funds also provide economies of scale. Buying one spares the investor of
the numerous commission charges needed to create a diversified portfolio.
Buying only one security at a time leads to large transaction fees, which will eat
up a good chunk of the investment. Also, the $100 to $200 an individual investor
might be able to afford is usually not enough to buy a round lot of the stock, but it
will purchase many mutual fund shares. The smaller denominations of mutual
funds allow investors to take advantage of dollar cost averaging.

Because a mutual fund buys and sells large amounts of securities at a time,
its transaction costs are lower than what an individual would pay for securities
transactions. Moreover, a mutual fund, since it pools money from many smaller
investors, can invest in certain assets or take larger positions than a smaller
investor could. For example, the fund may have access to IPO placements or
certain structured products only available to institutional investors.

Professional Management
A primary advantage of mutual funds is not having to pick stocks and manage
investments. Instead, a professional investment manager takes care of all of this
using careful research and skillful trading. Investors purchase funds because
they often do not have the time or the expertise to manage their own portfolios,
or they don't have access to the same kind of information that a professional fund
has. A mutual fund is a relatively inexpensive way for a small investor to get a
full-time manager to make and monitor investments. Most private, non-
institutional money managers deal only with high-net-worth individuals—people
with at least six figures to invest. However, mutual funds, as noted above, require
much lower investment minimums. So, these funds provide a low-cost way for
individual investors to experience and hopefully benefit from professional money
management.

Variety and Freedom of Choice

Investors have the freedom to research and select from managers with a variety
of styles and management goals. For instance, a fund manager may focus on
value investing, growth investing, developed markets, emerging markets,
income, or macroeconomic investing, among many other styles. One manager
may also oversee funds that employ several different styles. This variety allows
 investors to gain exposure to not only stocks and bonds but also commodities,
foreign assets, and real estate through specialized mutual funds. Some mutual
funds are even structured to profit from a falling market (known as bear funds).
Mutual funds provide opportunities for foreign and domestic investment that may
not otherwise be directly accessible to ordinary investors.

Transparency
Mutual funds are subject to industry regulation that ensures accountability and
fairness to investors.

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

Disadvantages of Mutual Funds

Liquidity, diversification, and professional management all make mutual funds
attractive options for younger, novice, and other individual investors who don't
want to actively manage their money. However, no asset is perfect, and mutual
funds have drawbacks too.

Fluctuating Returns
Like many other investments without a guaranteed return, there is always the
possibility that the value of your mutual fund will depreciate. Equity mutual funds
experience price fluctuations, along with the stocks that make up the fund. The
Federal Deposit Insurance Corporation (FDIC) does not back up mutual fund
investments, and there is no guarantee of performance with any fund. Of course,
almost every investment carries risk. It is especially important for investors in
money market funds to know that, unlike their bank counterparts, these will not
be insured by the FDIC.

Cash Drag
Mutual funds pool money from thousands of investors, so every day people are
putting money into the fund as well as withdrawing it. To maintain the capacity to
accommodate withdrawals, funds typically have to keep a large portion of their
portfolios in cash. Having ample cash is excellent for liquidity, but money that is
sitting around as cash and not working for you is not very advantageous. Mutual
funds require a significant amount of their portfolios to be held in cash in order to
satisfy share redemptions each day. To maintain liquidity and the capacity to
accommodate withdrawals, funds typically have to keep a larger portion of their
portfolio as cash than a typical investor might. Because cash earns no return, it is
often referred to as a "cash drag."

High Costs
Mutual funds provide investors with professional management, but it comes at a
cost—those expense ratios mentioned earlier. These fees reduce the fund's
overall payout, and they're assessed to mutual fund investors regardless of the
performance of the fund. As you can imagine, in years when the fund doesn't
make money, these fees only magnify losses. Creating, distributing, and running
a mutual fund is an expensive undertaking. Everything from the portfolio
manager's salary to the investors' quarterly statements cost money. Those
expenses are passed on to the investors. Since fees vary widely from fund to
fund, failing to pay attention to the fees can have negative long-term
consequences. Actively managed funds incur transaction costs that accumulate
over each year. Remember, every dollar spent on fees is a dollar that is not
invested to grow over time.

"Diworsification" and Dilution

"Diworsification"—a play on words—is an investment or portfolio strategy that
implies too much complexity can lead to worse results. Many mutual fund
investors tend to overcomplicate matters. That is, they acquire too many funds
that are highly related and, as a result, don't get the risk-reducing benefits of
diversification. These investors may have made their portfolio more exposed. At
the other extreme, just because you own mutual funds doesn't mean you are
automatically diversified. For example, a fund that invests only in a particular
industry sector or region is still relatively risky.
In other words, it's possible to have poor returns due to too much diversification.
Because mutual funds can have small holdings in many different companies,
high returns from a few investments often don't make much difference on the
overall return. Dilution is also the result of a successful fund growing too big.
When new money pours into funds that have had strong track records, the
manager often has trouble finding suitable investments for all the new capital to
be put to good use.

One thing that can lead to diworsification is the fact that a fund's purpose or
makeup isn't always clear. Fund advertisements can guide investors down the
wrong path. The Securities and Exchange Commission (SEC) requires that funds
have at least 80% of assets in the particular type of investment implied in their
names. How the remaining assets are invested is up to the fund manager.
However, the different categories that qualify for the required 80% of the assets
may be vague and wide-ranging. A fund can, therefore, manipulate prospective
investors via its title. A fund that focuses narrowly on Congolese stocks, for
example, could be sold with a far-ranging title like "International High-Tech
Fund."

Active Fund Management

Many investors debate whether or not the professionals are any better than you
or I at picking stocks. Management is by no means infallible, and even if the fund
loses money, the manager still gets paid. Actively managed funds incur higher
fees, but increasingly passive index funds have gained popularity. These funds
track an index such as the S&P 500 and are much less costly to hold. Actively
managed funds over several time periods have failed to outperform their
benchmark indices, especially after accounting for taxes and fees.

Lack of Liquidity
A mutual fund allows you to request that your shares be converted into cash at
any time, however, unlike stock that trades throughout the day, many mutual
fund redemptions take place only at the end of each trading day.

Taxes
When a fund manager sells a security, a capital-gains tax is triggered. Investors
who are concerned about the impact of taxes need to keep those concerns in
mind when investing in mutual funds. Taxes can be mitigated by investing in tax-
sensitive funds or by holding non-tax sensitive mutual funds in a tax-
deferred account, such as a 401(k) or IRA.

Evaluating Funds
Researching and comparing funds can be difficult. Unlike stocks, mutual funds
do not offer investors the opportunity to juxtapose the price to earnings (P/E)
ratio, sales growth, earnings per share (EPS), or other important data. A mutual
fund's net asset value can offer some basis for comparison, but given the
diversity of portfolios, comparing the proverbial apples to apples can be difficult,
even among funds with similar names or stated objectives. Only index funds
tracking the same markets tend to be genuinely comparable.

Example of a Mutual Fund

One of the most famous mutual funds in the investment universe is Fidelity
Investments' Magellan Fund (FMAGX). Established in 1963, the fund had an
investment objective of capital appreciation via investment in common stocks.
The fund's glory days were 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.5

Even after Lynch left, Fidelity's performance continued strong, and assets under
management (AUM) grew to nearly $110 billion in 2000, making it the largest
fund in the world. By 1997, the fund had become so large that Fidelity closed it to
new investors and would not reopen it until 2008.

As of July 2020, Fidelity Magellan has over $20 billion in assets and has been
managed by Sammy Simnegar since Feb. 2019.4 The fund's performance has
pretty much tracked or slightly surpassed that of the S&P 500.