A mutual fund buys investments with money it collects from selling shares in the fund. The idea of diversification is that it’s smarter to own a variety of stocks and bonds than trying to meet your financial goals based on the successful performance of just a few.

But diversifying can be a challenge because buying a portfolio of individual stocks and bonds can be expensive. And knowing what to buy—and when—takes time and concentration.

All types of mutual funds offer one solution:

mutual funds schematic graph

When you put money into a fund, it’s pooled with money from other investors to create much greater buying power than you would have investing on your own. In an actively managed fund, professional managers decide what to buy and when to sell. An index, or passively managed, fund holds all or some of the securities in an index.

As a fund shareholder, you own the fund’s underlying investments indirectly rather than outright, as you do when you buy stock. Since a fund may own dozens of different securities, its return isn’t dependent on just a few holdings.

how do mutual funds work

A Fund Snapshot

Investment companies (also called mutual fund companies), brokerage firms, banks, and insurance companies offer mutual funds for sale to individuals and institutional investors, such as money managers or pension funds. Most fund sponsors offer a range of funds, but some specialize in bond funds or stock funds. Each actively managed fund has an investment objective and a strategy for building its portfolio. So, the manager invests to produce a return, or gain, that’s stronger than the return of the market from which the fund’s investments are chosen and to outperform competing funds. Most index funds seek to replicate market returns.

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Paying Out The Profits

A mutual fund may make money in two ways: by earning dividends or interest on its investments and by selling investments that have increased in price. The fund distributes, or pays out, these profits (minus fees and expenses) to its investors. In other words, income distributions are paid from the income the fund earns on its investments. Capital gains distributions are paid from the profits from selling investments. Different funds pay their distributions on different schedules — typically monthly or quarterly. Many funds offer investors the option of reinvesting their distributions to buy more shares.
If you hold the fund in a taxable account, you owe taxes on the distributions you receive, whether the money is reinvested or paid out in cash. But if a fund loses more than it makes in any year, it can use the loss to offset future gains. Until profits equal the accumulated losses, distributions aren’t taxable, although the share price of the fund may increase to reflect the profits.

The Mutual Fund Market

Mutual funds never invest at random. Each shops for products that fit its investment strategy. Here are nine main types of mutual funds:

  1. Open-End Funds
  2. Closed-End Funds
  3. Stock Funds, also called equity funds, invest primarily in stocks.
  4. Bond Funds invest primarily in corporate or government bonds.
  5. Balanced Funds
  6. Environment Funds
  7. Social Funds
  8. Governance Funds
  9. Money Market Funds make short-term investments in an effort to keep their share value fixed at $1.

A TEAM APPROACH

A fund manager works with teams of analysts who evaluate fund holdings, assess the financial markets, and identify companies that may be appropriate additions to the fund portfolio. A fund also employs traders, who stay tuned to the market and buy or sell specific securities when the price is within the range the manager has set, based on the analysts’ research. The fund’s back office manages these transactions, which may involve buying and selling millions of dollars of securities each day.

At the close of the trading day—4 p.m. in New York—the fund determines its price per share, and all the buy and sell orders submitted during the day are transacted at that price.

The Part Diversity Plays

Most funds diversify their holdings by buying a wide variety of investments that correspond to their category. A typical stock fund, for example, might own stock in 100 or more companies providing a range of different products and services. The appeal of diversification is that losses on some stocks may be offset—or even outweighed—by gains on others. Some funds are extremely focused:

  • Precious metal funds trade chiefly in mining stocks.
  • Sector funds buy shares in a particular segment of the market, such as healthcare, technology, or utilities.
  • High-yield bond funds seek high income from low-rated bonds.

The attraction of focused funds is that when they’re doing well, the returns can be outstanding. The risk is that a change in investor demand, regulation, or the economy can intensify losses because the fund holdings aren’t more diversified.

Types Of Mutual Funds

Stock (Equity) Funds

In one way, the name says it all. Stock funds invest in stocks. But stock funds vary, depending on the fund’s investment objective, the universe of stocks from which it draws its portfolio, and its investment strategy or style. Most stock funds concentrate on a particular area within the overall stock market. A fund might invest in large, dividend-paying companies or promising small-cap companies. It might focus on new growth companies or those described as value investments, where a company’s stock price is lower than seems justified.

HOW-EQUITY-FUNDS-SCORE

Bond Funds

Like bonds, bond funds provide income. Unlike bonds, however, these funds have no maturity date, no fixed rate, and no guaranteed repayment of the amount you invest, in part because the fund’s holdings have different terms. On the plus side, you can reinvest your distributions to buy more shares.

And you can buy shares in a bond fund for much less than you would need to buy a bond portfolio on your own—and get a diversified portfolio to boot. For example, you can often invest $2,500 or less to open a fund, and make additional purchases for smaller amounts.

Bond funds come in many varieties, with different investment goals and strategies. There are investment-grade corporate bond funds and riskier junk-bond funds often sold under the promising label of high yield. You can choose long- or short-term US Treasury funds, funds that combine issues with different maturities, and a variety of tax-free municipal bond funds, including some limited to a particular state.

Open-End Funds

Most mutual funds are open-end funds. This means the fund sells as many shares as investors want. As money comes in, the fund grows. If investors want to sell, the fund buys their shares back. Sometimes open-end funds are closed to new investors when they grow too large to be managed effectively—though current shareholders can continue to buy shares. When a fund is closed in this way, the investment company may create a similar fund to capitalize on investor interest.
open-and-closed-end funds

Closed-End Funds

Closed-end funds more closely resemble stocks in the way they are traded. While these funds do invest in a variety of securities, they raise money only once and offer only a fixed number of shares that are traded on an exchange or over-the-counter. The market price of a closed-end fund fluctuates in response to investor demand as well as to changes in the value of its holdings.

Balanced Funds

You may want to consider funds tailored to help you meet specific investment goals or simplify building a diversified portfolio. Rather than choosing stock funds and bond funds to populate your portfolio, you may prefer a balanced fund. A balanced fund invests in both stocks and bonds, allocating a percentage to each—such as 60% to stocks and preferred stocks and 40% to bonds.

You can find the specific proportions in the fund’s prospectus. A balanced fund may provide a less volatile return than a fund investing in a single asset class.

Environment, Social, and Governance Funds

Environment, social, and governance funds attract investors whose strong convictions make them unwilling to put money into companies whose business practices are at odds with their beliefs. A fund might avoid companies with poor environmental records, with specific employment practices, or those selling certain products. In its prospectus, each fund explains the criteria, called screens, it uses to find acceptable investments.

Money Market Funds

Money market funds try to maintain their value at $1 a share, so they’re often described as cash equivalent investments. These funds may pay higher interest than bank accounts and can serve as useful holding accounts for money you’re about to invest. However, unlike bank or credit union deposits, money market funds are not federally insured, and it’s possible you could lose money. Regulations instituted in 2014 require institutional prime money funds to report a floating net asset value (NAV) and added other protections to prevent runs on funds that are losing value.

If you’re investing in mutual funds in a retirement savings plan, you may want to consider a target date fund, sometimes called a lifecycle fund. For example, if you plan to retire in 2035, you might choose XYZ Fund Retirement 2035. The XYZ fund company will invest primarily in stocks for a number of years, and then move more money into bonds and perhaps cash as 2035 gets closer, with the goal of achieving growth now to provide income later.

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