Understanding mutual funds: Types, investing styles, fees, and other basics

Open full sized image

A mutual fund is a collection of stocks, bonds, and/or other assets managed by a professional and offered as a single investment.

©blackwaterimages—E+/Getty Images

A mutual fund is a collection of investments, such as stocks and bonds, that you can buy as a single investment. For many decades, mutual funds have been a mainstay of company 401(k) plans and investment accounts, as they allow smaller investors to participate in a wide array of securities in one transaction. As of January 2022, U.S. investors held $27 trillion in more than 9,300 mutual funds.

Looking to invest in mutual funds, or want to learn more because they’re offered as part of your retirement plan? Here’s a rundown of the basics.

Companies and managers who sponsor and operate mutual funds do so according to the mutual fund’s prospectus—an official document that lays out the fund’s investment objectives, costs and fees, risks, and historical performance.

The prospectus defines the rules the fund will play by, including the types of investments it can hold. A fund’s choice set can be narrow—for example, it might invest only in small energy companies in South America. A fund can also be broad—for example, it might invest in anything the fund manager believes will deliver a healthy return, as long as it stays within the fund’s defined risk parameters as spelled out in the prospectus.

The value of a given mutual fund (called its net asset value or NAV) goes up or down each day based on the performance of the investments it holds. The NAV is calculated daily according to the closing prices of the investments in the fund.

Mutual funds are typically run by a portfolio manager who buys and sells stocks, bonds, and other fund assets in a manner consistent with the fund’s strategy. Some mutual funds are actively managed, with the management team using deep research and sophisticated analytics tools to try to maximize investment returns. Actively managed funds typically charge higher fees as a way of compensating the professionals who research, select, and monitor the investments.

Other funds, such as index funds, are managed more passively. The manager might invest in the components of a particular index, such as the S&P 500, to mirror the performance of that index. Because passively managed funds have lower overhead, they tend to charge lower management fees.

Whether a fund is passive or active, the appeal of mutual funds is the same: diversification. That is, mutual funds can help reduce the overall risk of a portfolio by investing in a variety of different stocks, bonds, and other assets.

And although each fund is unique, there are a few broad categories of funds you should know about.

Mutual funds can seem simple, but there are a few things to keep in mind. It’s especially important to understand the fees, because they come out of the fund’s assets and thus reduce its returns over time. Here are some common fees:

Together, the management, 12b-1, and administrative fees add up to the mutual fund’s expense ratio, which is the annual percentage of invested assets that you as an investor would pay each year. The expense ratio is a useful way to compare the fees charged by different funds.

Taxes are also a factor for mutual fund investors. You’ll have to pay annual income taxes on any interest payments or dividends you receive from a fund each year, even if that income is reinvested in the fund. You’ll also have to pay capital gains taxes on the underlying securities the fund sells for a gain during a given year. And when you sell a stock mutual fund, you’ll have to pay capital gains taxes on the returns you’ve earned.

There are exceptions to these tax rules if you own the funds in a tax-advantaged account such as an IRA, 401(k), or 529 plan. In tax-deferred accounts, you only owe taxes at the time you make withdrawals. The gains, losses, dividends, and interest have no tax impact until then. (With a Roth IRA, your contributions were made after you paid taxes on the money, so when you make withdrawals in retirement, you’ll owe no federal taxes.)

Mutual funds can offer a simple way to pursue your investing objectives. You can target an index or specific sectors or industries, tap the expertise of an experienced investment manager, or let a fund do the rebalancing and risk mitigation as you approach retirement. That’s one reason mutual funds continue to be a popular vehicle for investment and retirement savings, despite the significant cost and fee considerations.