How Do Mutual Funds Work?

Financial advisors often tell their clients to put the majority of their wealth in stock investments, because stocks have historically outperformed other types of investments over long periods of time. They also advise people not to but too much wealth into any particular stock, because committing a large amount of money to any single company can lead to a large loss of wealth if that company happens to perform poorly. Mutual funds are a common type of investment that can give investors exposure to stocks without putting too much money into any individual stock.

What is a Mutual Fund?

A mutual fund is a type of professionally investment where fund managers collect money from investors and use the money purchase a variety of assets such as stocks, bonds and commodities. Mutual fund investors receive shares with a value that is determined by the value of the assets that the fund holds. If the total value of the assets a mutual fund holds goes up, the share price of the fund rises and investors can potentially sell their shares to make a profit. If the stocks that mutual fund buys pay dividends, the fund may distribute those dividends to investors. Similarly, if fund managers decide to sell off some of the assets a fund holds and the sale results in a profit for the fund, the fund may distribute the profit to shareholders as a “capital gains distribution.” Investors must pay taxes on dividends and capital gains distributions received from mutual fund investments.

Types of Mutual Funds

Mutual funds come in three main types: stock funds, bond funds and money market funds. Stock funds invest heavily in stocks and often focus on a certain industry. For example, an energy mutual fund might commit all of its capital to stock in companies involved in the oil and gas industry. Index funds are a type of stock fund where managers purchase a wide range stocks in an attempt to provide investors with returns similar to the overall performance of a certain stock market index. Bond funds are mutual funds that invest heavily in bonds which may be high-risk, while money market funds invest in low-risk and short-term investments.

Advantages of Mutual Funds

Mutual funds are a popular alternative to investing directly in stocks because mutual funds spread risk across many different underling investments, a practice known as diversification. A single mutual fund might hold stock in hundreds of different companies. Even if a few of the stocks turn out to be bad apples, the mutual fund may still go up in value if other stocks it holds go up in value. A mutual fund can give individual investors a level of stock diversification that would be impossible for them to achieve by buying individual stocks.

Costs

Despite their advantages, mutual funds have a few drawbacks with respect to stocks and other investments. The biggest drawback of mutual funds is that they charge fees to compensate managers. Fees are often expressed as an annual percentage called an “expense ratio.” For example, if a mutual fund has an expense ratio of 0.25 percent it means that fund deducts a quarter of a percent of the value of your investment each year to pay fund managers. Funds impose the expense ratio regardless of whether they produce a return for investors.

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Elizabeth Goldman is the editor of AlternativeInvestmentCoach.com. She has written for Investing.com, Bullbearings.com and many others.