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Mutual funds: Here's what they are and how they work

At a glance:

  • What is a mutual fund and how does it work?

  • Buying and redeeming mutual funds

  • Mutual fund expenses

  • Mutual fund income and distributions

  • Types of mutual funds: The basics

  • Summary of Mutual Funds

Mutual funds are among the most popular investment vehicles. There are over 15,000 of them holding close to $9 trillion. In fact, there are more different mutual funds available to investors than there are different publicly traded corporations offering common stock.

Many people buy mutual funds because of their competitive returns. Others like them because they are easy to buy and sell or redeem. Still other investors like the fact that investment risk is diversified over many companies held in a mutual fund portfolio.

Mutual funds also provide professional portfolio management. Mutual funds can be chosen on the basis of fund investment objectives that match the individual investor's objectives. However, there is a cost for the management and convenience of mutual funds, which is borne by the portfolio and paid in the form of various fees and charges.

Nevertheless, mutual funds are a convenient and potentially rewarding way for investors of all levels of sophistication to invest.

What is a mutual fund and how does it work?

A mutual fund is an investment company that raises money from investors to invest in stocks, bonds, and other securities. It is a portfolio made up of several individual investments. When those investments gain or lose value, you gain or lose as well. When they pay dividends, you get a share of them.

Mutual funds also offer professional management and diversification. They do much of your investing work for you.

Investing in mutual funds involves risk, including possible loss of principal. Investments in specialized industry sectors have additional risks, which are outlined in the prospectus.

Open-end and closed-end

Mutual funds may be open-end or closed-end funds. The term mutual funds is used most often to mean open-end funds. Open-end funds issue new shares continuously as investors buy them. Investors redeem their shares directly to the fund, which in turn must buy them back.

Closed-end funds issue a fixed number of shares that the funds may redeem only upon termination of their trusts. Shareholders in a closed-end fund may, however, sell their shares through a broker on the secondary market to other investors, but not back to the fund. Closed-end funds are commonly referred to as exchange-traded funds (ETFs).

Buying and redeeming mutual funds

You can buy mutual fund shares directly from a mutual fund company or from a securities broker. Either way, buying and redeeming are relatively easy. To buy shares directly from a mutual fund, you send money to the fund. Redeeming shares works the same way.

In all cases, the customer (you) executes all transactions with the mutual fund company. Many funds also allow you to redeem shares over the telephone.

Invest on auto pilot

You can also set up an automatic investment plan to do your work for you. Under this plan, you can have a fixed amount of money withdrawn monthly from a financial institution account and sent to the fund. Using this option requires that you first authorize it on your application form. Most mutual funds allow it.

Many funds require initial investments of $1,000 or more, depending on the fund. However, many of them waive this requirement if you agree to an automatic investment plan that withdraws from your account until you reach the required minimum.

Use a broker

Buying shares from a broker works much the same way. The primary difference is that the broker saves you the work of executing your own orders, since in this arrangement it is his or her responsibility to execute all transactions with the mutual fund company. The majority of mutual funds purchased from brokerage firms also allow the customer to benefit from the ability to easily redeem shares or participate in automatic investment plans.

For specific details on how your brokerage fund handles the processes of buying and redeeming mutual fund shares, be sure to ask your broker.

Exchange-traded funds

Note: exchange-traded funds have become more popular recently. Unlike open-end funds, exchange-traded funds do not buy and sell securities in their portfolios daily. Since the portfolio value always depends upon the market value of the same pool of securities, exchange-traded funds are traded in the secondary stock market rather than redeemed by the mutual fund company, as are open-end mutual funds.

Mutual fund expenses

Mutual funds charge fees for the costs of running their funds. A mutual fund's prospectus lists all the fees that the fund charges.

Various mutual fund fees

  • A sales charge is a fee you pay when purchasing shares of a mutual fund. By law, sales charges may not exceed 8.5 percent of the amount invested. Funds with sales charges are called load funds.

  • Funds with no sales charge are called no-load funds.

  • Redemption fees are charges that may be imposed when investors sell shares back to a fund. If a fund has a redemption fee that decreases over time, it is called a contingent deferred sales charge. This may be used as an incentive to investors to keep their money invested. For example, a contingent deferred sales charge might start at 5 percent and decrease by one percentage point per year until it hits zero.

  • Mutual funds may charge 12b-1 fees to cover expenses such as advertising, brokers' costs and toll-free telephone lines.

  • They also may charge management fees, and they may charge transfer fees (if you transfer money from one fund to another within the same fund family).

Why you pay these expenses

Above all, it is important to understand the fees that you are paying, as most investments have a cost of some kind. Fees can vary, sometimes significantly, so make sure to compare your options. When considering mutual funds, remember that charges, fees, loads, and commissions are payment for the operating and administrative aspects of running the fund. If you don't need the benefits of a mutual fund or if the costs are exorbitant, you might want to consider other alternatives. On the other hand, if you perceive value for those costs, they should not be a deterrent to making an investment.

Mutual fund income and distributions

Mutual funds offer more than one source of income.

Dividends

Mutual funds pay their shareholders dividends from the earnings of the stocks, bonds, and other securities in the funds. You can receive dividends as cash, or you can reinvest them into the funds. Many funds will automatically reinvest your dividends if you authorize them to.

Most dividends will be taxed at favorable long-term capital gains rates. If the dividends come from a return of capital or a tax-free municipal bond fund they will be tax-free. If the dividends are received within a tax-favored retirement account, the tax will be deferred.

Capital gains distributions

Another source of potential income in mutual funds is capital gains distributions. When a security in a fund is sold, any gain (or loss) on it must be distributed to shareholders. You can receive your capital gains dividends as cash, or you can have them reinvested.

The taxation rules that apply to dividends also apply to capital gains dividends.

Change of fund share price

You may also benefit from share price increases. These are the rises in value of a share of your fund. If the price of one share increases by one dollar, you have made a gain of one dollar times the number of shares you own. This type of gain is called paper profit because you do not receive it until you sell shares. Once you have sold the shares, you then have a capital gain.

Conversely, a fund can decrease in value as well. Should you sell your investment at a capital loss, you may be eligible to use those losses to offset the gains of other investments for tax purposes. Consult your tax advisor to learn more.

All of these sources of gain make up the total return of a mutual fund. Depending on the type of account and investment, you may need to consider the effect that taxes may have on your total return.

Types of mutual funds

Stock mutual funds

Stock funds invest primarily in common stocks of corporations to provide growth in value. They bring the stock market to the investor who may not have the time or ability to pick stocks or construct a portfolio. These funds are usually growth-oriented, since stocks provide growth.

Growth funds are a type of stock fund structured to grow over time. These funds invest primarily in stocks of corporations that are viewed to have potential for growth. Growth funds may choose businesses or smaller companies that have the potential to grow quickly. Growth companies often forgo paying dividends to their customers because growth companies reinvest their earnings.

Bond mutual funds

Bond funds invest primarily in bonds to provide income with safety of principal. They bring the world of bond investing to the small investor. Most bond funds are conservative, focusing on payment of dividends. That said, investing in bond mutual funds still involves risk, including possible loss of principal. Investors can choose among several types of bond funds. Below are some of the most popular:

Municipal bond funds

Municipal bond funds invest in debts issued by state and local governments. Their dividends may be free from federal taxes.

Government bond funds

Government bond funds invest in debts of the US government and its agencies. These funds include mortgage-backed securities as well as bills, notes, and bonds of the US Treasury.

Corporate bond funds

Corporate bond funds invest in debts issued by companies in the private sector.

Zero coupon bond funds

Zero coupon bond funds are pools of zero coupon bonds. A zero coupon bond is a bond that is sold to an investor at a discount. It does not pay interest. When it matures, the investor receives the face value of the bond. The difference between the face value and the discounted purchase prices is treated as interest.

International bond funds

International bond funds invest in debts of governments and corporations of other nations.

Convertible securities funds

Convertible securities funds invest in debt securities that can be converted into stock. These funds have the objective of current income and growth with preservation of principal. Thus, they offer characteristics of stocks and bonds.

Goals of bond funds

Bond funds generally pay periodic income dividends, which can be taken in cash or reinvested. Their primary goal is current income and preservation of principal, although bond fund prices fluctuate and may result in loss of principal in an unfavorable bond market.

Additional notes about bond mutual funds

Municipal bond funds: Subject to availability and change in price. Municipal bonds in the fund are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income on some private activity bonds may be subject to the alternative minimum tax. Exempt-interest dividends are federally tax-free, but other state and local taxes may apply with special rules often applying to residents buying bonds issued by their own state.

Government bond funds: An investor can lose money when investing in government bond funds. The funds themselves are not guaranteed, and the funds' performance will vary.

Zero coupon bonds: Zero coupon bonds are subject to large price fluctuations if sold prior to maturity. Investors pay ordinary income tax on zero coupon bonds every year even when no payments have been received.

Money market mutual funds

Money market mutual funds invest in the short-term debts of corporations, federal and state governments, and their subsidiaries.

What money market funds invest in

They bring these investments to the small investor for an initial investment as low as $500 (depending on the fund). Money market funds invest in Treasury bills, commercial paper, banker's acceptances, negotiable certificates of deposit, repurchase agreements, and short-term debts of US government agencies. A fund's prospectus lists each investment and how much of it the fund has bought.

The returns on money market funds depend on the yields of their individual holdings. Money market instrument yields can fluctuate greatly. This causes the yields of money funds to fluctuate as well. Investors who hold money market funds can track the funds' yield changes in the financial pages of most major newspapers.

An investment in the fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.

Hybrid mutual funds

There are mutual funds that do not specialize in a particular security such as stocks or bonds, but may instead combine several types of securities in their portfolios. These funds are structured to meet an objective such as rapid growth, matching a market index, or investing in one area of the economy. They use combinations of securities to meet their goals. We will look at several of these "hybrid funds."

Income funds

Income funds are structured to provide regular income dividends to their investors. These funds invest in "income securities" of corporations or governments (including preferred stock, bonds, and money market investments). Such securities yield relatively stable current income. They focus on paying dividends as their top priority while de-emphasizing the growth in value of their portfolios. Preservation of capital is a concern. Income funds are popular with investors who want stable income from their mutual funds.

Index funds

Index funds are popular among investors wishing to keep their mutual funds' performance in line with "the market." These funds buy the securities that make up major market indexes. The advantage of index funds is that they are always in line with their market index. Their downside is that they cannot outperform the market. Some funds divide their holdings evenly among the various stocks. Some use dollar weighting so that bigger companies make up a larger share.

Balanced funds

Balanced funds seek to balance growth and income in one portfolio. To do this, they invest in common stock, preferred stock, bonds, and cash equivalents. Hypothetically, these funds have a "balanced" ratio of these asset types. Managers of balanced funds can, however, shift this ratio one way or the other to take advantage of high interest rates or stock market growth. Balanced funds generally have low volatility and are popular with investors seeking current income with growth potential.

Growth & income funds

Growth & income funds are similar to balanced funds. However, they rely mostly on growth stocks that pay dividends.

Funds that mix stocks, bonds, money market instruments, as well as other class assets are better able to allocate capital toward the end of achieving a particular investment goal. Such funds are used by investors with similar investment goals.

Summary of mutual funds

Mutual funds are the most popular investment vehicle. There are currently more mutual funds in which to invest than there are corporations offering common stock to the public. This occurs because many mutual funds invest in some securities of the same corporations, as do other funds, only in different amounts.

Mutual funds are diversified portfolios of securities representing a microcosm of investments. Some offer investors portfolios designed to meet specific investment objectives such as long-term growth, current income, or even speculation in specific industry sectors.

Mutual funds may be suitable for any type of investor as long as they are selected based upon the investor's means, risk tolerance, needs, and goals.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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