What Is a Mutual Fund?

When you’re investing, diversification is typically the name of the game. But if you’re not into picking individual stocks, how do you get a diverse basket of investments? Enter the mutual fund. A mutual fund can give you access to an entire portfolio of stocks, bonds or other securities in one transaction.

While mutual funds tend to be a more accessible solution than buying individual stocks or bonds yourself, there are still some things you should know about them. We’ll explain what a mutual fund is, how it works and how it may benefit your financial plan.

What is a mutual fund?

A mutual fund pools the investment dollars of a group of shareholders and is professionally managed, buying stocks, bonds or other securities based on the mutual fund’s investment objective. Mutual funds take the guesswork out of building a diverse portfolio one stock at a time. What’s more, mutual funds don’t just buy stocks. They come in all shapes and flavors.

Odds are, if you want to add broad market exposure or narrow to a particular corner of the market, there are several mutual funds to choose from. A mutual fund’s performance history, style, benchmark and other key information is all spelled out in a document known as the prospectus. It’s important to read the fund’s prospectus carefully before investing.

Types of mutual funds

When thinking about what types of mutual funds to invest in, you’ll usually think in terms of what type of growth you’re looking to achieve. Funds with more growth potential typically come with higher risk of loss, so you should also keep your risk tolerance in mind when selecting funds.

By their nature, different types of funds are positioned to help you achieve your desired level of potential growth. Here are some of the most popular mutual fund categories:

Stocks

Buying mutual funds that invest in shares of companies is one way to pursue more significant growth. Mutual funds that invest in stocks can be organized by:

• Company size (Small Cap, Mid Cap, Large Cap)

• Sector or style (Industrials, Value stocks, ESG)

• Geography (U.S., China, International Developed Emerging Markets, Asia Pacific)

Bonds

Bonds may help provide more stability in a portfolio. Bond mutual funds are usually organized by:

• Type (e.g. Corporate, High-Yield, Municipal)

• Geography (e.g. state-specific municipal bonds, U.S. Treasury bonds, emerging-market bonds)

Index funds

An index fund is a fund that invests in a mix of assets that’s designed to track a certain market index, like the S&P 500. Index funds are typically passive investments and are usually organized by the index they track.

Money market funds

Money market funds invest short-term debt securities from governments and companies and certificates of deposit (CDs). In selecting a money market fund, you’ll usually take into account its allocation strategy (fixed, dynamic, etc.).

Asset allocation funds

In addition, you can buy funds that are allocated among several asset classes, such as stocks, bonds or other investments. One example of this is a target-date fund, which shifts its allocation over time, typically reducing risk as it approaches the target date (usually retirement).

Specialty funds

There are also mutual funds that buy other types of investments, such as commodities or real estate. Or, you can invest in companies that meet certain criteria, like only targeting companies that meet environmental, social and governance (ESG) criteria.

Passive management vs. Active management

In addition to differences in the types of investments that a fund may hold, there are also differences in how they are managed. A passive fund simply mirrors a benchmark—typically an index like the S&P 500 or NASDAQ. Passive fund fees are typically lower. However, these funds are unlikely to outperform the index they track because they attempt to mirror that very index and have underlying expenses.

However, in an active fund, a manager researches and picks stocks based on a proprietary formula and investment approach. While fees are typically higher than a passive fund, over time, active managers attempt to add value in the form of better returns by making investment decisions that differ from its benchmark. Of course, active managers could also underperform a passive fund or benchmark.

How a mutual fund works

One key difference between a mutual fund and other types of investments is how it trades or, more specifically, how the price of the fund is set. Unlike typical investments that go up and down during trading hours, most mutual funds are priced and traded once daily.

A mutual fund is priced once a day (after the market closes), and the daily net asset value (NAV, or price) is derived from the value of the securities held in the fund and shares outstanding. Your investment then changes in value along with the NAV.

How does a mutual fund make money?

A mutual fund can make money in a few ways. When a fund’s NAV increases in value, you can sell your shares for a profit. Mutual funds also often pay dividends (quarterly or monthly income) and capital gain distributions (resulting from the sale of investments within the fund that were sold at a profit). Keep in mind, however, that they can also lose money as the market fluctuates.

Mutual fund fees

Typically, with a mutual fund, you’ll need to pay any fees to cover what goes on inside the fund (like transaction fees), unlike exchange-traded funds (ETFs) which generally don’t carry as many fees. Actively managed mutual funds will also likely include higher fees to cover the fund manager’s time. Here are some of the fees you may encounter when investing in a mutual fund:

Expense Ratio

This is a fee charged by the managers for annual administration and operating costs. An expense ratio can range from 0.01 percent to 1 percent (or even more) depending on the fund and what the fund manager needs to do to maintain the fund. In 2022, the average equity mutual fund had an expense ratio of 0.44 percent.

Loads

When you buy or sell shares of a mutual fund, you may pay a load fee, which is a sales fee or commission paid to the firm or investment professional. These are commonly front-end loads, which means you pay a percentage of the amount that you invest up front.

No-load mutual funds, which don’t carry any commission charge, also exist; however, these funds don’t necessarily come without fees. Instead, redemption fees (fees a shareholder pays to the fund when they redeem shares), exchange fees (fees to exchange funds) or purchase fees (fees paid to the fund vs. the company upon a purchase) could apply.

Pros and cons of investing in mutual funds

As with any investment, there are some perks and downsides to investing in mutual funds.

Pros of investing in mutual funds

Mutual funds also provide access to a lot of different securities at varying levels of risk, so they’re a great option for diversifying your portfolio. Because funds are professionally managed, they’re relatively low maintenance for the investor. Mutual funds shares are also relatively easy to trade, buy and sell, so they can be pretty flexible investments.

Cons of investing in mutual funds

With a mutual fund, someone is managing the fund for you, so there are often higher fees associated with this investment compared to ETFs and other investment types. You’re also relinquishing control of your investment to the mutual fund manager. As with any investment, mutual funds carry some level of risk, including the potential loss of principal invested. There is no guarantee that you’ll make money, and if you do, you’ll typically have to pay capital gains taxes on any earnings.

How to invest in mutual funds

Mutual funds offer an easy way to diversify your portfolio to work toward achieving your financial goals without the need to research dozens of individual investments and keep a constant eye on the markets. Here’s how to get started:

Determine your investment budget

If you haven’t already, put together a monthly budget that takes into account your savings, fixed expenses and discretionary spending. This will help you determine how much money you’ll have to invest.

Identify what you’re saving for

A mutual fund is only one investment option. There are other ways to help grow your money, and depending on what you’re saving for, there may be a more tax-advantaged option. For example, if you’re saving for retirement, a Roth IRA might make more sense or if you’re saving for college, you may want to consider a 529 plan.

Consult with a financial advisor

Even if you have a general idea of what you’d like to invest, there are still a lot of decisions to be made. Rather than navigating them all on your own, consider reaching out to a Northwestern Mutual financial advisor to help get you started. An advisor can help you design an investment strategy that helps all your assets—mutual funds, retirement savings, life insurance and more—work together to reach your financial goals.

No investment strategy can guarantee a profit or protect against a loss. Northwestern Mutual and its financial representatives do not give tax advice. Taxpayers should seek advice regarding their particular circumstances from an independent accounting or tax adviser.