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Part of the Series Mutual Funds: Different Types and How They Are PricedMutual Funds Basics
CURRENT ARTICLETypes of Mutual Funds
Mutual Fund Costs
Mutual funds are pooled investments managed by professional money managers. They trade on exchanges and provide an accessible way for investors to get access to a wide mix of assets that are selected for the fund.
A mutual fund is an investment vehicle that pools money from multiple investors to purchase a diversified portfolio of stocks, bonds, or other securities (according to the fund's stated strategy).
It allows individual investors to gain exposure to a professionally-managed portfolio and potentially benefit from economies of scale, while spreading risk across multiple investments.
Mutual funds are defined as a portfolio of investments funded by all the investors who have purchased shares in the fund. So, when an individual buys shares in a mutual fund, they gain part-ownership of all the underlying assets the fund owns. The fund's performance depends on how its collective assets are doing. When these assets increase in value, so does the value of the fund's shares. Conversely, when the assets decrease in value, so does the value of the shares.
The mutual fund manager oversees the portfolio, deciding how to divide money across sectors, industries, companies, etc., based on the strategy of the fund. About half of the mutual funds held by American households are in index equity funds, which have portfolios that comprise and weigh the assets of indexes to mirror the S&P 500 or the Dow Jones Industrial Average (DJIA). The largest mutual funds are managed by Vanguard and Fidelity. They are also index funds. These generally have limited investment risk, unless the entirety of the market goes down. Nevertheless, over the long run, index funds tied to the market have gone up, helping to meet the investment objectives of many future retirees.
By 2023, over half of American households had investments in mutual funds, collectively owning 88% of all mutual fund assets. This marks a significant increase from just a few decades ago, when, in 1980, less than 6% of U.S. households were invested in mutual funds. Today, much of the retirement savings of middle-income Americans are tied up in these funds.
When setting aside money in mutual funds, households can access a broad range of investments, which can help cut their 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. Mutual funds are often the investment of choice for middle America, providing a broad swath of middle-income workers with professionally managed portfolios of equities, bonds, and other asset classes.
Most mutual funds are part of larger investment companies or fund families such as Fidelity Investments, Vanguard, T. Rowe Price, and Oppenheimer.
Investors typically earn returns from a mutual fund in three ways:
When researching the returns of a mutual fund, you'll typically come upon a figure for the "total return," or the net change in value (either up or down) over a specific period. This includes any interest, dividends, or capital gains the fund has generated along with the change in its market value during a given period. In most cases, total returns are given for one, five, and 10-year periods, as well as from the day the fund opened or inception date.
There are many types among the more than 8,700 mutual funds in the U.S., with most in four main categories: stock, money market, bond, and target-date funds.
As the name implies, this fund invests principally in equity or stocks. Within this group are assorted subcategories. Some equity funds are named for the size of the companies they invest in: firms with small-, mid-, or large-sized capitalization. Others are named by their investment approach: aggressive growth, income-oriented, and value. Equity funds are also categorized by whether they invest in U.S. stocks or foreign equities. To understand how these strategies and sizes of assets can combine, you can use an equity style box like the example below.
Value funds invest in stocks their managers see as undervalued while aiming at long-term appreciation when the market recognizes the stocks' true worth. These companies are characterized by low price-to-earnings (P/E) ratios, low price-to-book ratios, and dividend yields. Meanwhile, growth funds look to companies with solid 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." These funds invest in a mix of growth and value stocks to give a risk-to-reward profile somewhere in the middle.
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Large-cap companies have market capitalizations of over $10 billion. Market cap is derived by multiplying the share price by the number of shares outstanding. Large-cap stocks are typically for blue-chip firms whose names are recognizable. Small-cap stocks have a market cap between $250 million and $2 billion. These companies tend to be newer, riskier investments. Mid-cap stocks fill in the gap between small- and large-cap.
A mutual fund may combine different investment styles and company sizes. For example, a large-cap value fund might include in its portfolio large-cap companies that are in strong financial shape but have recently seen their share prices fall; these would be placed in the upper left quadrant of the style box (large and value). The opposite of this would be a small-cap growth fund that invests in startup technology companies with high growth prospects. This kind of fund is in the bottom right quadrant above (small and growth).
A mutual fund that generates a consistent and minimum return is part of the fixed-income category. These mutual funds focus on investments that pay a set rate of return, such as government bonds, corporate bonds, and other debt instruments. The bonds should generate interest income that's passed on to the shareholders, with limited investment risk.
There are also actively managed funds seeking 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 when and when they invest, and all bond funds are subject to risks related to changes in interest rates.
Index mutual funds are designed to replicate the performance of a specific index, such as the S&P 500 or the DJIA. This passive strategy requires less research from analysts and advisors, so fewer expenses are passed on to investors through fees, and these funds are designed with cost-sensitive investors in mind.
They also frequently outperform actively managed mutual funds and thus potentially are the rare combination in life of less cost and better performance.
Balanced funds invest across different securities, whether stocks, bonds, the money market, or alternative investments. The objective of these funds, known as an asset-allocation fund, is to cut risk through diversification.
Mutual funds detail their allocation strategies, so you know ahead of time what assets you're indirectly investing in. Some funds follow a strategy for dynamic allocation percentages to meet diverse 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 fund's stated strategy.
The money market consists of safe, risk-free, short-term debt instruments, mostly government Treasury bills. The returns on them aren't substantial. 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). Money market mutual funds are often used as a temporary holding place for cash that will be used for future investments or for an emergency fund. While low risk, they aren't insured by the Federal Deposit Insurance Corporation (FDIC) like savings accounts or CDs.
Income funds are meant to disburse income on a steady basis, and are often seen as the mutual funds for retirement investing. They invest primarily in government and high-quality corporate debt, holding these bonds until maturity to provide interest streams. While fund holdings may rise in value, the primary goal is to offer a steady cash flow.
An international mutual fund, or foreign fund, invests only in assets located outside an investor's home country. Global funds, however, can invest anywhere worldwide. Their volatility depends on where and when the funds are invested. However, these funds can be part of a well-balanced, diversified portfolio since the returns from abroad may provide a ballast against lower returns at home.
Often international in scope, regional mutual funds are investment vehicles that focus on a specific geographic region, such as a country, a continent, or a group of countries with similar economic characteristics. These funds invest in stocks, bonds, or other securities of companies that are headquartered, or generate a significant part of their revenue, within a targeted region.
Examples of regional mutual funds include Europe-focused mutual funds that invest in that continent's securities; emerging market mutual funds, which focus on investments in developing economies worldwide; and Latin America-focused mutual funds that invest in countries like Brazil, Mexico, and Argentina.
The main advantage of regional mutual funds is that they allow investors to capitalize on the growth potential of specific geographic areas and diversify their portfolios internationally. However, these funds also carry unique risks, such as political instability, currency fluctuations, and economic uncertainties, though they depend on the region.
Sector mutual funds aim to profit from the performance of specific sectors of the economy, such as finance, technology, or health care. Theme funds can cut across sectors. For example, a fund focused on AI might have holdings in firms in health care, defense, and other areas employing and building out AI beyond the tech industry. Sector or theme funds can have volatility from low to extreme, and their drawback is that in many sectors, stocks tend to rise and fall together.
Socially responsible investing (SRI) or so-called ethical funds invest only in companies and sectors that meet preset criteria. For example, some socially responsible funds do not invest in industries like tobacco, alcoholic beverages, weapons, or nuclear power. Sustainable mutual funds invest primarily in green technology, such as solar and wind power or recycling.
There are also funds that review environmental, social, and governance (ESG) factors when choosing investments. This approach focuses on the company's management practices and whether they tend toward environmental and community improvement.
Investing in mutual funds is relatively straightforward and involves the following steps:
When investing in mutual funds, it's essential to understand the fees associated with them, as these costs will significantly affect your investment returns over time. Here are some common mutual fund fees:
Expense ratio: This is an annual fee that covers the fund's operating expenses, including management fees, administrative costs, and marketing expenses. The expense ratio is expressed as a percentage of the fund's average net assets and is deducted from the fund's returns. Pressured by competition from index investing and exchange-traded funds (ETFs), mutual funds have lowered the expense ratio by more than half over the last 30 years. In 1996, equity mutual fund investors incurred expense ratios of 1.04% ($1.04 for every $100 in assets). By 2022, that average had fallen to 0.44%, according to the Investment Company Institute. The fees for bond mutual funds were slightly less at 0.37%, and hybrid models, which often require more management, had expense fees averaging 0.59%.
Sales charges or loads: Some mutual funds charge sales fees, known as "loads," when you buy or sell shares. Front-end loads are charged when you buy shares, while back-end loads (or contingent and deferred sales charges) are assessed if you sell your shares before a certain date. Sometimes, however, management firms offer no-load mutual funds, which don't have commission or sales charges.
Redemption fees: Some mutual funds charge a redemption fee when you sell shares within a short period (usually 30 to 180 days) after purchasing them, which the U.S. Securities and Exchange Commission (SEC) limits to 2%. This fee is designed to discourage short-term trading in these funds for stability.
Other account fees: Some funds or brokerage firms may charge extra fees for maintaining your account or transactions, especially if your balance falls below a certain minimum.
While many mutual funds are "no-load," you can frequently avoid brokerage fees and commissions anyway by purchasing a fund directly from the mutual fund company instead of going through an intermediary.
If you're trying to cut your fees, you'll want to watch the type of mutual fund shares you buy. Traditionally, individual investors would buy mutual funds with A-shares through a broker. Then, a front-end load of up to 5% or more, plus management fees and ongoing fees for distributions (also known as 12b-1 fees), would be tacked on. Financial advisors selling these products may encourage clients to buy higher-load offerings to generate commissions. With front-end funds, the investor pays for these expenses as they buy into the fund.
To remedy these problems and meet fiduciary-rule standards, investment companies have designated new share classes, including "level load" C shares, which generally don't have a front-end load but carry a 12b-1 annual distribution fee of up to 1%.
Funds that charge management and other fees when investors sell their holdings are classified as Class B shares.
The value of the mutual fund depends on the performance of the securities it invests in. When buying a unit or share of a mutual fund, you get a part of its portfolio value. Investing in a share of a mutual fund differs from investing in stock shares. Unlike stock, mutual fund shares do not give their holders voting rights. And unlike ETFs, you can't trade your shares throughout the trading day.
Mutual fund share prices come from the net asset value (NAV) per share, sometimes listed on platforms as NAVPS. A fund's NAV is derived by dividing the total value of the securities in the portfolio by the number of shares outstanding.
Mutual fund shares are typically bought or redeemed at the fund's NAV, which doesn't fluctuate during market hours but is settled at the end of each trading day. The price of a mutual fund is also updated when the NAVPS is settled.
There are many 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. The SEC, in particular, has long paid very close attention to how these funds are run, given their importance to so many Americans and their retirements.
Diversification, or the mixing of investments and assets within a portfolio to reduce risk, is one of the advantages of investing in mutual funds. A diversified portfolio has securities with different capitalizations and industries and bonds with varying maturities and issuers. A mutual fund can achieve diversification faster and more cheaply than buying individual securities.
Trading on the major stock exchanges, mutual funds can be bought and sold with relative ease, making them highly liquid investments. Also, for certain types of assets, like foreign equities or exotic commodities, mutual funds are often the most workable way—sometimes the only way—for individual investors to participate.
Mutual funds also provide economies of scale. Buying only one security at a time could lead to hefty transaction fees. Mutual funds also enable investors to take advantage of dollar-cost averaging, which is putting away a set amount periodically, no matter the changes in the market.
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. A mutual fund can invest in certain assets or take larger positions than a smaller investor could.
A professional investment manager uses research and skillful trading. A mutual fund is a relatively inexpensive way for a small investor to get a full-time manager to make and monitor investments. Mutual funds require much lower investment minimums, providing a low-cost way for individual investors to experience and benefit from professional money management.
Mutual funds are subject to industry regulations meant to ensure accountability and fairness for investors. In addition, the component securities of each mutual fund can be found across many platforms.
You can research and choose from funds with different management styles and goals. A fund manager may focus on value investing, growth investing, developed markets, emerging markets, income, or macroeconomic investing, among many other styles. This variety enables investors to gain exposure not only to stocks and bonds but also to commodities, foreign assets, and real estate through specialized mutual funds. Mutual funds provide prospects for foreign and domestic investment that might otherwise be inaccessible.
Mutual fund managers are legally obligated to follow the fund's stated mandate and to work in the best interest of mutual fund shareholders.
Liquidity, diversification, and professional management all make mutual funds attractive options. However, there are drawbacks:
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 in the fund's portfolio. The FDIC does not guarantee mutual fund investments.
Mutual funds require a significant part of their portfolios to be held in cash to satisfy share redemptions each day. To maintain liquidity and the ability to accommodate withdrawals, mutual funds typically have to keep a larger percentage of their portfolio as cash than other investors. Because this cash earns no return, it's called a "cash drag."
Fees that reduce your overall payout from a mutual fund are assessed whatever the performance of the fund. Failing to pay attention to the fees can cost you since actively managed funds incur transaction costs that accumulate and compound year over year.
Dilution is also the result of a successful fund growing too big. When new money pours into funds with solid track records, the manager could have trouble finding suitable investments for all the new capital to be put to good use.
The SEC requires that funds have at least 80% of assets in the particular type of investment implied by their title. How the remaining assets are invested is up to the fund manager. However, the categories that qualify for 80% of the assets can be vague and wide-ranging. Some less scrupulous fund managers might manipulate prospective investors via their fund titles. For example, a fund that focuses narrowly on Argentine stocks could be sold with a much-more-ranging title like "International High-Tech Fund."
A mutual fund allows you to request that your shares be converted into cash at any time. However, unlike stocks and ETFs that trade throughout the day, mutual fund redemptions can only take place at the end of the trading day.
When the mutual fund manager sells a security, a capital-gains tax is triggered, which can be extended to you. ETFs, for example, avoid this through their creation and redemption mechanism. Your taxes can be lowered 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.
Researching and comparing funds can be more difficult than for other securities. 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 NAV 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.
"Diworsification"—a play on words that defines the concept—is an investment term for when too much complexity can lead to worse results. Many mutual fund investors tend to over-complicate matters. That is, they acquire too many funds that are too similar and, as a result, lose the benefits of diversification.
Among 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. 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.
As of March 2024, Fidelity Magellan has about $33 billion in assets, managed by Sammy Simnegar since 2019. The S&P 500 is the fund's primary benchmark.
Index funds are mutual funds that aim to replicate the performance of a market benchmark or index. For example, an S&P 500 index fund tracks that index by holding the 500 companies in the same proportions. A key goal of index funds is minimizing costs to mirror their index closely.
By contrast, actively managed mutual funds try to beat the market by stock picking and shifting allocations. The fund manager seeks to achieve returns greater than a benchmark through their investing strategy and research.
Index funds offer market returns at lower costs, while active mutual funds aim for higher returns through skilled management that often comes at a higher price. When deciding between index or actively managed mutual fund investing, investors should consider costs, time horizons, and risk appetite.
| Index vs. Active Mutual Funds | ||
|---|---|---|
| Attribute | Index Funds | Active Funds |
| Goal | Match a market index | Outperform the market |
| Management Style | Passive, automated | Active by fund managers |
| Fees | Low expense ratios | Higher expense ratios |
| Performance | Average market returns | Attempt to beat averages |
Mutual funds and ETFs are pooled investment funds that offer investors a stake in a diversified portfolio. However, there are some crucial differences.
Among the most important is that ETF shares are traded on stock exchanges like regular stocks, while mutual fund shares are traded only once daily after markets close. This means ETFs can be traded anytime during market hours, offering more liquidity, flexibility, and real-time pricing. This flexibility means you can short sell them or engage in the many strategies you would use for stocks.
Another significant difference is pricing and valuation. ETF prices, like stocks, fluctuate throughout the day according to supply and demand. Meanwhile, mutual funds are priced only at the end of each trading day based on the NAV of the underlying portfolio. This also means that ETFs have the potential for larger premiums/discounts to NAV than mutual funds.
Compared with mutual funds, ETFs tend to have certain tax advantages and are often more cost-efficient.
All investments involve some degree of risk when purchasing securities such as stocks, bonds, or mutual funds—and the actual risk of a particular mutual fund will depend on its investment strategy, holdings, and manager's competence. Unlike deposits at banks and credit unions, the money invested in mutual funds isn't FDIC or otherwise insured.
Yes. Mutual funds are generally highly liquid investments, meaning you can redeem your shares on any business day. However, it's important to be aware of any potential fees or penalties associated with early withdrawals, such as redemption fees or short-term trading fees, which some funds impose to discourage people from trading in and out of the funds frequently.
Withdrawing funds may have tax implications, particularly if the investment has appreciated in value, which means you'll have to pay taxes on the capital gains.
Yes, many make money for retirement and other savings goals through capital gains distributions, dividends, and interest income. As securities in the mutual fund's portfolio increase in value, the value of the fund's shares typically rises, leading to capital gains. In addition, many mutual funds pay out dividends from the income the fund has earned by the securities they hold. If the fund holds bonds, then it will earn interest on them. However, returns are not guaranteed, and the performance of a mutual fund depends on market conditions, the fund's management, what assets it holds, and its investment strategy.
Depending on the assets they hold, mutual funds carry several investment risks, including market, interest rate, and management risk. Market risk arises from the potential decline in the value of the securities within the fund. Interest rate risk affects funds holding bonds and other fixed-income securities, as rising interest rates can lead to a decrease in bond prices.
Management risk is linked to the performance of the fund's management team. You are putting your money in their hands, and poor investment decisions will negatively impact your returns. Before investing, it's important for investors to carefully review the fund's prospectus and consider their own risk tolerance and investment objectives.
When investing in a 401(k) or other retirement savings account, target-date or life cycle funds are popular. Choosing a fund that builds toward your retirement, like a hypothetical FUND X 2050 (which would target a 2050 retirement year), means investing in a mutual fund that rebalances and automatically shifts its risk profile to a more conservative approach as the target date gets closer.
Mutual funds are versatile and accessible for those looking to diversify their portfolios. These funds pool money from investors for stocks, bonds, real estate, derivatives, and other securities—all managed for you. Key benefits include access to diversified, professionally managed portfolios and choosing among funds tailored to different objectives and risk tolerances. However, mutual funds come with fees and expenses, including annual fees, expense ratios, or commissions, that will help determine your overall returns.
Investors can choose from many types of mutual funds, such as stock, bond, money market, index, and target-date funds, each with its investment focus and strategy. The returns on mutual funds come from distributions of income from dividends or interest and selling fund securities at a profit.
