- A common type of investment company, mutual funds are open-end funds, meaning that investors can purchase and redeem shares in the funds on a daily basis based on the net asset value (NAV) of their shares.
- Mutual funds pool the money of many investors to purchase a range of securities to meet specified objectives, such as growth, income or both.
- Mutual funds can offer cost-effective diversification.
- Each mutual fund has a different investment objective. Some funds invest in a particular product, such as stocks or bonds. Some focus on a particular industry or region. Others seek to replicate a market index.
- All mutual funds have fees and expenses. Use FINRA’s Fund Analyzer to analyze and compare the costs of owning specific funds.
- A mutual fund may have different share classes with different costs. Your investment professional might receive higher (or lower) commissions or payments for the sale of one share class relative to another.
- It’s important to read a mutual fund’s prospectus to learn about its objectives, investments, strategies and costs.
Mutual funds are a popular way to invest in securities. Because mutual funds can offer built-in diversification and professional management, they offer certain advantages over purchasing individual stocks and bonds. But, like investing in any security, investing in a mutual fund involves certain risks, including the possibility that you might lose money.
A mutual fund is a type of investment company, known as an open-end fund, that pools money from many investors and invests it based on specific investment goals. The mutual fund raises money by selling its own shares to investors. The money is used to purchase a portfolio of stocks, bonds, short-term money-market instruments, other securities or assets, or some combination of these investments. Each share represents an ownership slice of the fund and gives the investor a proportional right, based on the number of shares they own, to income and capital gains that the fund generates from its investments.
The particular investments a fund makes are determined by its objectives and, in the case of an actively managed fund, by the investment style and skill of the fund's professional manager or managers. The holdings of the mutual fund are known as its underlying investments, and the performance of those investments, minus fund fees, determine the fund's investment return.
All of the details about a mutual fund—including its investment strategy, risk profile, performance history, management and fees—are provided in its prospectus. You should always read the prospectus before investing in a fund.
How They Work
Mutual funds are equity investments, as individual stocks are. When you buy shares of a fund, you become a part owner of the fund, and you share in its profits. For example, when the fund's underlying stocks or bonds pay income from dividends or interest, the fund pays those profits, after expenses, to its shareholders in payments known as income distributions. Also, when the fund has capital gains from selling investments in its portfolio at a profit, it passes on those after-expense profits to shareholders as capital gains distributions. You generally have the option of receiving these distributions in cash or having them automatically reinvested in the fund to increase the number of shares you own.
All mutual funds have fees, with some charged at specific times, based on actions you take, and some are charged on an ongoing basis. Each fund's prospectus describes its fees in detail. You can also analyze and compare the costs of owning funds by using FINRA’s Fund Analyzer.
Mutual funds are registered with the Securities Exchange Commission (SEC) and are subject to SEC regulation.
Learn how mutual funds compare to exchange-traded funds.
Understanding Investment Companies
Investment companies can be structured as either open-end or closed-end funds—although most investment companies are open-end funds, known more commonly as mutual funds. One of the key distinguishing features of a mutual fund is that investors can buy and sell shares at any time. The fund will create new shares to meet increased demand and buy back shares from investors who want to sell. Sometimes, mutual funds get so large that they close to new investors. Even if a mutual fund is closed, however, it still remains an open-end fund since existing shareholders can continue to buy and sell fund shares.
Mutual funds calculate the value of one share, known as the net asset value (NAV), only once a day, when the investment markets close. All purchases and sales for the day are recorded at that NAV. To figure its NAV, a fund adds up the total value of its investment holdings, subtracts the fund's fees and expenses, and divides that amount by the number of shares that investors are currently holding.
Unlike stock prices, NAV isn't necessarily a measure of a fund's success. Since mutual funds can issue new shares and buy back old ones all the time, the number of shares and the dollars invested in the fund are constantly changing. That's why it makes more sense to compare mutual funds by looking at their total return over time rather than comparing their NAVs. But always remember that past returns don’t necessarily predict future returns.
Closed-end funds, which are a less common type of investment company, differ from open-end funds because they raise money only once in a single offering, much the way a company might raise money at its initial public offering (IPO). After the shares are sold, the closed-end fund uses the money to buy a portfolio of underlying investments, and any further growth in the size of the fund depends on the return on its investments, not new investment dollars. The fund is then listed on an exchange, the way an individual stock is, and shares trade throughout the day.
The price for closed-end funds rises and falls in response to investor demand and may be higher or lower than its NAV or the actual per-share value of the fund's underlying investments.
A third type of investment company, the unit investment trust (UIT), has characteristics of both mutual funds and closed-end funds. A UIT invests the money raised from many investors during its one-time public offering in a generally fixed portfolio of stocks, bonds or other securities. Unlike either mutual funds or closed-end funds, though, UITs have a preset termination date, at which time any remaining investment portfolio securities are sold, with the proceeds paid to the investors.
While there are thousands of individual mutual funds, there are only a handful of major fund categories:
- stock funds, which invest in stocks;
- bond funds, which invest in bonds;
- balanced funds, which invest in a combination of stocks and bonds; and
- money market funds, which invest in very short-term investments and are sometimes described as cash equivalents.
Within the major categories of mutual funds, there are individual funds with a variety of investment objectives, or goals, the fund wants to meet on behalf of its shareholders. Here’s just a sampling of the many you might find:
- Growth funds invest in stocks that the fund's portfolio manager believes have potential for significant price appreciation.
- Value funds invest in stocks that the fund's portfolio manager believes are underpriced in the secondary market.
- Equity income funds invest in stocks that regularly pay dividends.
- Stock index funds are passively managed funds that attempt to replicate the performance of a specific stock market index by investing in the stocks held by that index.
- Small-, mid- or large-cap stock funds stick to companies within a certain size range. Economic cycles tend to favor different sized companies at different times, so, for example, a small-cap fund may be doing very well at a time when large-cap funds are stagnant and vice versa.
- Socially responsible funds invest according to political, social, religious or ethical guidelines, which you'll find described in the fund's prospectus. Many socially responsible funds also take an activist role in the companies where they invest by representing their shareholders' ethical concerns at meetings with company management.
- Sector funds specialize in stocks of particular segments of the economy. For example, you might find funds that specialize solely in technology stocks, in healthcare stocks and so on. Sector funds tend to be less diversified than funds that invest across sectors, but they do provide a way to participate in a potentially profitable segment of the economy without having to identify specific companies.
- International, global, regional, country-specific or emerging markets funds extend their reach beyond the U.S. International funds invest exclusively in non-U.S. companies. Global funds may invest in stocks of companies all over the world, including U.S. companies with global businesses. Regional funds focus on stocks of companies in a particular region, such as Europe, Asia or Latin America, while country-specific funds narrow their range to stocks from a single country. Funds that invest in emerging markets look for stocks in developing countries.
There’s an important distinction between owning an individual bond and owning a fund that owns the bond. When you buy a bond, you’re promised a specific rate of interest and return of your principal. That's not the case with a bond fund, which owns a number of bonds with different rates and maturities. Equity ownership of a bond fund provides the right to a share of what the fund collects in interest, realizes in capital gains, and receives back if it holds a bond to maturity.
- Corporate, agency or municipal bond funds focus on bonds from a single type of issuer, across a range of different maturities.
- Short- or intermediate-term bond funds focus on short- or intermediate-term bonds from a wide variety of issuers.
- Treasury bond funds invest in Treasury issues.
- High-yield bond funds invest in lower-rated bonds with higher coupon rates.
- Balanced funds invest in a mixture of stocks and bonds to build a portfolio diversified across both asset classes. The target percentages for each type of investment are stated in the prospectus. Because stocks and bonds tend to do well during different phases of an economic cycle, balanced funds may be less volatile than pure stock or bond funds.
- Funds of funds are mutual funds that invest in other mutual funds. While these funds can achieve much greater diversification than any single fund, their returns are affected by the fees of both the fund itself and the underlying funds. Also, redundancy might cut down on diversification, such as if several of the underlying funds hold the same investments.
- Target-date funds, sometimes called lifecycle funds, are funds of funds that change their investments over time to meet goals you plan to reach at a specific time, such as retirement. Typically, target-date funds are sold by date, such as a 2035 fund. The farther away the date is, the greater the risks the fund usually takes. As the target date approaches, the fund changes its balance of investments to emphasize conserving the value it has built up and to shift toward income-producing investments.
- Money market funds invest in short-term debt, such as Treasury bills and the very short-term corporate debt known as commercial paper. These investments are considered cash equivalents. Money market funds invest with the goal of maintaining a share price of $1. They’re sometimes considered an alternative to a bank savings account, although they aren't insured by the Federal Deposit Insurance Corporation (FDIC). Some funds have private insurance.
SEC rules require a mutual fund to invest at least 80 percent of its assets in the type of investment suggested by its name. But funds can still invest up to one-fifth of their holdings in other types of securities—including securities that you might consider too risky or perhaps not aggressive enough. Investors should check the latest quarterly report showing the fund's major investment holdings to see how closely the fund manager is sticking to the strategy described in the prospectus and whether you might be exposed to any risks you aren’t prepared to take on.
Active vs. Passive
When a fund is actively managed, it employs a professional portfolio manager, or team of managers, to decide which underlying investments to choose for its portfolio. In fact, one reason you might choose a specific fund is to benefit from the expertise of its professional managers. A successful fund manager has the experience, knowledge and time to seek and track investments—key attributes that many investors may lack.
The goal of an active fund manager is to beat the market—to get better returns by choosing investments that they believe to be top-performing selections. While there’s a range of ways to measure market performance, each fund is measured against an appropriate market index, or benchmark, based on its stated investment strategy and the types of investments it makes.
For instance, many large-cap stock funds typically use the S&P 500 Index as the benchmark for their performance. A fund that invests in stocks across market capitalizations might use the Dow Jones Wilshire 5000 Total Stock Market Index, which measures more than 5,000 small-, mid- and large-company stocks. Other indexes that track only stocks issued by companies of a certain size, or that follow stocks in a particular industry, are the benchmarks for mutual funds investing in those segments of the market. Similarly, bond funds measure their performance against a standard, such as the yield from the 10-year Treasury bond, or against a broad bond index that tracks the yields of many bonds.
One of the challenges portfolio managers face in providing stronger-than-benchmark returns is that their funds' performance needs to compensate for their operating costs. The returns of actively managed funds are reduced first by the cost of hiring a professional fund manager and second by the cost of buying and selling investments in the fund. Suppose, for example, that the management and administrative fees of an actively managed fund are 1.5 percent of the fund's total assets and the fund's benchmark provided a 9 percent return. To beat that benchmark, the portfolio manager would need to assemble a fund portfolio that returned better than 10.5 percent to account for those fees. Anything less, and the fund's returns would lag its benchmark.
In any given year, most actively managed funds don’t beat the market. In fact, studies show that very few actively managed funds provide stronger-than-benchmark returns over long periods of time, including those with impressive short-term performance records. That's why many individuals invest in funds that don't try to beat the market at all. These are passively managed funds, otherwise known as index funds.
Passive funds seek to replicate the performance of their benchmarks instead of outperforming them. For instance, the manager of an index fund that tracks the performance of the S&P 500 typically buys a portfolio that includes all of the stocks in that index in the same proportions as they are represented in the index. If the S&P 500 were to drop a company from the list, the fund would sell its shares in that company, and if the S&P 500 were to add a company, the fund would buy that company’s stock. Because index funds don't need to retain active professional managers, and because their holdings aren't as frequently traded, they normally have lower operating costs than actively managed funds. However, the fees vary from index fund to index fund, which means the return on these funds varies as well.
Some index funds, which go by names such as enhanced index funds, are hybrids. Their managers pick and choose among the investments tracked by the benchmark index in order to provide a superior return. In bad years, this hybrid approach might still be able to produce positive returns or returns that are slightly better than the overall index. Of course, it's always possible that this type of hybrid fund won’t do as well as the overall index. In addition, the fees for these enhanced funds might be higher than the average for index funds.
All mutual funds charge fees and expenses, some of which you pay directly (like sales charges and redemption fees) and others that come out of the fund's assets (to pay for such things as managing the fund’s portfolio, or marketing and distribution). These fees and expenses can vary widely from fund to fund or fund class to fund class. Even small differences in expenses might make a big difference in your return over time.
FINRA provides an easy-to-use, online Fund Analyzer that allows you to compare expenses among funds—or among different share classes of the same fund. Using a live data feed that captures expense information for thousands of funds, the analyzer can help you understand the impact fees, expenses and discounts have on your investment over time. Once you select up to three funds and type in the amount you plan to invest and how long you plan to keep the fund, the analyzer does the rest. See our overview of the Fund Analyzer and the different comparisons that can be modeled in the tool.
Here are types of fees that may be charged on an ongoing basis:
- Management fees – These fees pay the fund's portfolio manager.
- 12b-1 fees – These fees, capped at 1 percent of your assets in the fund, are taken out of the fund's assets to pay for the cost of marketing and selling the fund, for some shareholder services, and sometimes to pay employee bonuses.
- Other expenses – This miscellaneous category includes the costs of providing services to shareholders outside of the expenses covered by 12b-1 fees or portfolio management fees. You also pay transaction fees for the trades the fund makes, though this amount isn’t reported separately as the other fees are.
The following fees may also apply based on actions you take:
- Account fees – Funds may charge you a separate fee to maintain your account, especially if your investment falls below a set dollar amount.
- Redemption fees – To discourage very short-term trading, funds often charge a redemption fee to investors who sell shares shortly after buying them. Redemption fees may be charged anywhere from a few days to over a year. So it's important to understand if and how your fund assesses redemption fees before you buy, especially if you think you might need to sell your shares shortly after purchasing them.
- Exchange fees – Some funds also charge exchange fees for moving your money from one fund to another fund offered by the same investment company.
- Purchase fees – Whether or not a fund charges a front-end sales charge, it may assess a purchase fee at the time you buy shares of the fund.
One easy way to compare mutual funds fees is to look for the fund's total annual fund operating expenses, otherwise known as the fund's expense ratio. This percentage, which you’ll find in a fund's prospectus, on the fund's website, or in financial publications, will tell you the percentage of the fund's total assets that goes toward paying its recurring fees every year. The higher the fund's fees, the greater its handicap in terms of doing better than the overall market as measured by the appropriate benchmark.
For example, if you were considering two similar funds, Fund ABC and Fund XYZ, you might want to look at their expense ratios. Suppose Fund ABC had an expense ratio of 0.75 percent of assets, while Fund XYZ had an expense ratio of 1.85 percent. For Fund XYZ to match Fund ABC in annual returns, it would need a portfolio that outperformed Fund ABC by more than a full percentage point. Remember, though, that the expense ratio doesn’t include loads, which are fees you may pay when you buy or sell your fund. It also doesn’t include any discounts or waivers the fund or your brokerage firm might offer.
You should also be aware of transaction fees, which the mutual fund pays to a brokerage firm to execute its buy and sell orders. Those fees aren’t included in the expense ratio but are subtracted before the fund's return is calculated. The more the fund buys and sells in its portfolio, which is reported as its turnover rate, the higher its transaction costs may be.
When you buy mutual fund shares through an investment firm, you might have to pay sales charges, called loads, which are calculated as a percentage of the amount you invest. Like commissions on stock or bond transactions, these charges compensate the firm or investment professional. Key terms to know include:
- Front-end load: a commission you pay at the time you buy the shares, which can range between 2 percent and 5 percent
- Back-end load: a charge you pay only if you sell your shares during the period the charge applies, which can be several years after purchase
- Level load: an amount the fund collects every year you hold the fund
- No-load: funds that don’t impose sales charges but might have other fees (You typically buy no-load shares directly from the investment company that offers these funds.)
The rate at which you're charged varies from fund company to fund company. In addition, different classes of shares assess the charge at different times. Be sure you understand the financial consequences of choosing a specific share class before you purchase a fund.
Sometimes load funds offer volume discounts for higher investment amounts, in much the way that supermarkets sometimes offer economy bargains for buying certain things in bulk. In the case of funds, a front-end load may be reduced if you invest a certain amount. The amounts at which your sales charges drop are called breakpoints. The breakpoints are different for each fund, and your investment firm must tell you what they are and must apply breakpoints if your investment qualifies.
Breakpoint policies vary, but some funds let you qualify for breakpoints if all your investments within the same fund family—funds offered by the same fund company—add up to the breakpoint level. Some funds let the total investments made by all the members of your household count toward the breakpoint. In addition, some funds let you qualify for a breakpoint over time, instead of with a single investment, by adding your past investments to your new ones. You might even qualify for a breakpoint if you write a letter of intent, informing the fund that you're planning to invest enough to qualify for the breakpoint in the future.
In short, funds can offer breakpoints any number of ways, or they may not offer them at all. Whenever you're entitled to breakpoints, however, the fund is required to apply them to your investment.
Sales Charge Waivers
To maximize your investment, be sure to understand and explore any potential sales charge waivers. Some waivers to be aware of:
- Mutual Fund Exchanges – Mutual funds typically allow investors to sell shares in one fund and purchase shares in another fund in the same fund family on the same date without incurring sales charges.
- Rights of Reinstatement – A fund family may allow customers to redeem or sell shares in a fund and reinvest some or all of the proceeds without paying a sales charge or recoup some or all of a contingent deferred sales charge (CDSC). Generally, in order to be eligible for this type of waiver:
- the reinvestment must be made within a specified period of time (e.g., 90 days, although time periods may vary substantially across fund families);
- the redemption and reinvestment must take place in the same account;
- the redeemed shares must have been subject to a front-end or deferred sales charge; and
- the redemption and reinvestment must comply with any other terms and conditions required by certain investment companies (e.g., reinvestments must be made in the share class of the redeemed fund).
- NAV Transfers – Some fund families allow customers to purchase Class A shares without paying the front-end sales charge if the customer purchases such shares using proceeds from the sale of shares in a different mutual fund family for which the investor paid a front-end or back-end sales charge; these transactions are sometimes referred to as "NAV transfers." Most fund families that allow for such waivers require the customer to invest the proceeds from the sale within 30 to 90 days.
- Waivers for Retirement Accounts and Charities – Some fund families waive the front-end sales charges associated with Class A shares for certain retirement plans and charitable organizations.
- Waivers for 529 Plans – 529 plans offer sales charge waivers in a variety of specific situations, such as:
- existing account owners currently investing in charge-waived A shares;
- group 529 plans;
- plans purchased through an investment adviser;
- certain customers approved for discount by the program manager or broker-dealer;
- rollovers from qualified 529 plans; or
- special share classes.
You’ll have to pay taxes on a mutual fund's income distributions, and usually on its capital gains, if you own the fund in a taxable account. You might have short-term capital gains, which are taxed at the same rate as your ordinary income—something you might try to avoid when you sell your individual securities. You might also owe capital gains taxes if the fund sells some investments for more than it paid to buy them, even if the overall return on the fund is down for the year or if you became an investor of the fund after the fund bought those investments in question.
If you own the mutual fund in a tax-deferred or tax-free account, such as an individual retirement account, no tax is due on any of these distributions when you receive them. But you’ll owe tax at your regular rate on all withdrawals from a tax-deferred account.
You might also make money from your fund shares by selling them back to the fund, or redeeming them, if the underlying investments in the fund have increased in value since the time you purchased shares in the funds. In that case, your profit will be the increase in the fund's per-share value, also known as its NAV. Here, too, taxes are due the year you realize gains in a taxable account, but not in a tax-deferred or tax-free account. Capital gains for mutual funds are calculated somewhat differently than gains for individual investments, and your brokerage firm or the fund will let you know your taxable share of the fund's gains each year.
Because most mutual funds offer a level of built-in diversification, they’re typically considered a lower risk investment. However, as with all investments, there are still risks involved, and mutual fund returns aren’t guaranteed. Mutual funds also assume some of the risks of the assets that they hold, so be sure to brush up on the risks of those asset classes as well before you invest.
Inflation rates can impact the overall purchasing power of your investment. Increases in inflation rates and the cost of living may erode your purchasing power and reduce your overall returns.
Interest Rate Risk
In particular, interest rate fluctuations can impact bond prices. Rising interest rates, for example, cause bond prices to decline, which might also lead to a decline in the value of mutual funds with significant bond investments.
While investors can trade individual securities throughout the day, mutual funds are typically priced and traded only once daily, at the end of the day. Even if you enter a trade early in the day, the price you ultimately receive may be higher or lower depending upon the NAV at the time of actual execution.
Mutual fund performance is based upon the performance of their underlying investments; therefore, changing market conditions can impact principal and returns. Depending upon the specific assets held, a mutual fund might face general market risks based on economic or political conditions, natural disasters and other systemic events with broad impact, such as terrorist-related incidents, which could impact the value of your assets.
The following resources offer additional information on mutual fund investing.