What are mutual funds? What to know to start investing

• A mutual fund is a portfolio of investments that pools money from investors to purchase stocks, bonds, or other securities.
• The majority of mutual funds are professionally managed with the aim to outperform the market.
• Though they come with fees, mutual funds can add value to your portfolio by offering professional management and diversification.

A mutual fund is a type of investment vehicle that pools money from many investors to purchase stocks, bonds, or other securities. Investors who mutually contribute to the fund company become part owners of the fund's portfolio and the income it generates or loses.

"Mutual funds are an easy and well-established way to give everyday investors diversification," says Michael Iachini, vice president and head of manager research for Charles Schwab Investment Advisory. "They are well established since the 1920s, and they have a track record of working for investors."

While mutual funds have been around for decades, investors are increasingly becoming hip to their benefits. In 2020, 45.7% of US households owned mutual funds, compared to just 5.7% in 1980 according to an Investment Company Institute (ICI) survey.

Here's what to know about mutual funds, including how they work, what to watch out for, and how to get started investing in them.

How do mutual funds work?

Generally, mutual funds are actively managed by a fund manager who controls when to buy and sell securities in order to maximize returns and minimize losses. When you buy a mutual fund, you're buying partial ownership of the fund and its assets, meaning its entire portfolio of investments.

This differs from buying an individual stock, where you buy partial ownership directly in a company and manage any subsequent moves yourself (unless you have a financial manager).

The price of a mutual fund is determined by its net asset value (NAV), which takes all of the portfolio's securities into account. It is found by dividing the total value of the fund's assets (cash and securities) by the number of the fund's outstanding shares.

Since a mutual fund's portfolio consists of many securities that change price throughout the day, the NAV is calculated at the end of the market day. Because of this, mutual funds trade only once per day, after the markets close.

Example: Let's say you want to put $2,000 toward a mutual fund. If the fund's NAV is $20, you're able to purchase 100 shares - not counting fees. Along with other investors' contributions, that $2,000 would then be used by the fund manager to make trades with the goal of outperforming the market.

Mutual fund fees

You should be aware that mutual funds come with structured fees for active management, which eat into your total profits. A mutual fund will label fees into two main categories:

• Annual fund operating expenses: A fund's total annual operating expenses include management and transaction fees, which are expressed collectively as the fund's expense ratio. While relatively small, expense ratios can significantly affect a fund's return, especially over time.

• Shareholder fees: A fund can also come with shareholder fees, which cover commissions regarding buying and selling the fund. Most mutual funds will have a sales charge called a "load," which can be a flat fee or a commission, and occur when you purchase or sell your shares back to the fund.

If you're in the market for a mutual fund, its fees are an important factor to consider. You can find all associated fees outlined in detail in the fund's prospectus.

How to make money investing in mutual funds

You can make money on mutual funds in a few different ways:

• Dividend payments
: Similar to stocks, a mutual fund can pay out dividends to its investors periodically. They can choose to receive these payouts as cash or to reinvest them in your account.
• Capital gains
: When an investor sells a fund at a profit, that's known as a capital gain. This gain gets passed off to a fund's shareholders annually.
• NAV: If your mutual fund's value increases, the price to purchase its shares will also increase. This benefits you if you choose to sell your shares since you would sell at a gain.

Quick tip: When looking at NAV, you want to follow how a fund's value changes over time, rather than comparing one fund's value to another in a single day.

What are the pros and cons of mutual funds?

Before you add mutual funds to your portfolio, there are advantages and disadvantages that can help you decide whether they are the right fit for your investment style and goals.

Pros

• Offers simplicity and peace of mind with professional fund managers.
• Typically requires a small minimum investment to buy in.
• Adds diversification to your portfolio with various asset classes and industries held in one fund.
• Ability to invest with exact dollar amounts versus buying shares of stocks at fluctuating prices.

Cons

• Professional management fees can be costly.
• Mutual funds are not insured by the Federal Deposit Insurance Corporation (FDIC), so there is the risk of losing money.
• There's a chance of dilution decreasing the worth of your shares when a successful mutual fund grows too big.
• You have no control over a fund manager's decisions, which can trigger tax implications like capital gains that add to your taxable income.
• Since mutual funds trade after markets close, they don't allow for trading during the day and taking immediate advantage of market movements.

Types of mutual funds

Mutual funds aren't homogenous. They are classified into many different types, including the securities they invest in and the investment goals they seek to achieve. Here are seven of the major types:

1. Equity funds

Equity funds invest mostly in stocks and are often categorized by company size and market capitalization. Equity funds can be labeled as growth, value, or blended funds. Growth funds hold shares of companies with potential to outperform the overall market, while value funds are filled with stocks of seemingly undervalued companies. Blended funds mix both growth and value stocks.

2. Bond funds

Bond funds pool investors' money to primarily purchase bonds, from short- to long-term maturities. Some funds include a range of securities including government bonds, corporate bonds, and mortgage-backed securities, while others may focus on a specific part of the bond market.

Bond funds provide quick diversification without buying various bonds individually. Many funds also distribute dividends each month, which you can reinvest.

3. Money market funds

Money market funds are fixed-income mutual funds that invest in short-term debt securities with low credit risk. These funds aim to provide liquidity, maintain a stable share price, and distribute regular income earned on its securities to its investors.

Money market funds are categorized as government, prime, or tax-exempt, depending on the securities held within the fund. Securities often invested in money market funds include short-term US Treasury securities, federal agency notes, certificates of deposit, corporate commercial paper, and municipal agency obligations.

4. Balanced funds

Balanced mutual funds invest in both bonds and stocks, so you get the best of both worlds with steady income and investment growth. Also known as asset allocation funds, these funds typically stick to their original asset mix. If any changes are made, the funds are automatically rebalanced to bring them back to the original allocation.

5. Index funds

Index funds are a type of mutual fund designed to mirror the performance of a particular market index, like the S&P 500 or the Dow Jones Industrial Average. Because index funds are built to match the performance of the target index, they are passively managed investments. This means they require less research and trading from the fund manager, so there are fewer fees and expenses.

It's important to note that while an index fund can be structured as a mutual fund, it can also be an exchange-traded fund (ETF). Index funds are especially favored by investors because they are a low-risk, low-maintenance, low-cost way to see steady returns over time.

6. Specialty funds

Specialty funds, or sector funds, concentrate on securities within a specific industry or market sector, such as real estate, technology, or healthcare. Examples of specialty funds include real estate mutual funds, which invests in REITs and other real estate-related investments. Because specialty funds are focused on specific sectors like health care and technology, they aren't diverse so you'll want to mix these in with other types of funds and assets.

7. Target-date funds

Target-date funds operate with a specific goal date in mind. These funds automatically rebalance the asset mix within their portfolio over time and become more risk-averse as the target date nears. Target-date funds are popular for retirement savings since you can set your retirement date as the target, and let the fund adjust for you.

How to start investing in mutual funds

You likely have already invested in mutual funds if you have a 401(k) retirement account. But if you want to start investing in mutual funds outside of employer-sponsored accounts, you can buy and sell them through an online broker with a brokerage account.

You can also buy mutual funds directly from the company that created the fund, like Vanguard or Fidelity, although that limits your options to whatever they offer. If you need more guidance with your investments, you could consider working with a financial advisor or broker.

Each fund and each brokerage account may require a specific minimum investment amount to get started. "You typically don't need a lot of money in a mutual fund," says Iachini. "At least have $100 saved up. Once you've chosen a fund, look at its asset class, expense ratio, investment objective, whether that's income, growth, or intentionally trying to be conservative, and who is managing the fund."

It helps to ask yourself a few questions to help narrow down your options. How involved in rebalancing your asset allocation do you want to be? What are you saving for? What do you value? For example, if you're saving for retirement, you'll want to look to target-date funds. Or perhaps you want to look for ESG funds that invest in socially conscious companies.

The financial takeaway

Mutual funds are popular among investment experts for the easy diversification they bring to investment portfolios. If you're looking to invest in mutual funds, just make sure to keep an eye on costs, since actively managed mutual funds can eat into your profits with expense ratios and commissions. Beginner investors may be better off choosing index funds over actively managed funds to snag earnings without a big price tag.