What is a mutual fund and how does it work

A mutual fund is a pooled investment vehicle where money from many investors is combined to purchase a diversified portfolio of stocks, bonds, or other securities under professional management.

Think of it as a basket: you and thousands of other investors put money into that basket, and a professional manager uses the combined funds to buy a variety of investments.

Each investor owns shares representing a proportional stake in the fund's holdings and participates in gains or losses.

As of 2025, over 53.7% of U.S. households (approximately 71 million households) own mutual funds, according to the Investment Company Institute, making them one of America's most popular investment vehicles.

Mutual funds are regulated by the SEC under the Investment Company Act of 1940, providing investor protections through disclosure requirements.

This article will explain how mutual funds work, their types, costs, benefits, and risks.

Mutual funds operate on a straightforward pooling concept:

• When you invest in a mutual fund, your money is combined with contributions from thousands of other investors.
• The fund uses this collective capital to purchase a diversified portfolio of securities.
• Each investor owns shares proportional to their investment.
• If you invest $1,000 and the fund has $10 million in total assets, you own 0.01% of everything the fund holds.

What Is the Fund's Manager Role

The fund manager or management team plays a central role. These professionals research securities, make buy and sell decisions, and rebalance the portfolio to pursue the fund's stated objectives.

For example, a large-cap growth fund manager will focus on established companies with strong earnings momentum, while a bond fund manager will evaluate interest rate trends and credit quality.

You're essentially hiring expertise you might not have time or knowledge to replicate on your own.

What Is the Net Asset Value

Net asset value is the fund’s net worth (assets minus liabilities) recalculated at the close of each business day.

In other words, every business day, the fund calculates its net asset value (or NAV) at least once, typically after markets close at 4:00 p.m. ET. The calculation is simple: total all assets (stocks, bonds, cash), subtract liabilities (expenses, fees), and divide by the number of outstanding shares.

Here's a concrete example: a fund with $205,250,000 in assets, $22,050,000 in liabilities, and 10 million shares outstanding has an NAV of $18.32 per share.

All purchases and redemptions on a given day occur at that day's closing NAV. This distinguishes mutual funds from stocks, which trade continuously at fluctuating prices throughout the trading session.

How Do You Earn Returns From Mutual Funds

You earn returns from mutual funds in three ways:

• First, dividend and interest income: when stocks in the portfolio pay dividends or bonds pay interest, the fund collects that income and distributes it to shareholders, typically quarterly.
• Second, capital gains distributions: when the manager sells securities that have appreciated in value, the fund realizes capital gains and distributes them to shareholders, usually annually.
• Third, NAV appreciation: when the overall market value of the portfolio increases, your shares become more valuable. You can choose to receive distributions as cash deposited to your account or automatically reinvest them to purchase additional shares, compounding your growth over time.

Mutual funds are 'open-end' investment companies, meaning they continuously issue new shares when investors buy and redeem shares when investors sell.

The fund doesn't have a fixed number of shares like a corporation. When you want to invest, the fund creates new shares at the current NAV. When you want to sell, the fund buys back your shares at the current NAV and retires them. This structure provides liquidity and flexibility for investors.

Mutual funds come in several primary categories, each designed for different investment goals and risk tolerances.

Equity or Stock Funds

Represent 53.2% of total mutual fund assets, according to ICI data. These funds invest primarily in stocks and offer capital appreciation potential but come with higher volatility.

Within equity funds, you'll find subcategories:

• Large-cap funds focus on established companies like Apple or Microsoft with market capitalizations above $10 billion.
• Mid-cap funds target medium-sized companies with market caps between $2 billion and $10 billion, offering a balance of stability and growth potential.
• Small-cap funds invest in smaller companies under $2 billion in market cap, carrying higher risk but potentially higher rewards.
• Growth funds seek companies with strong earnings growth, even if their stock prices seem expensive.
• Value funds hunt for underpriced companies trading below their intrinsic worth.
• Income or dividend funds focus on stocks that pay regular dividends, appealing to investors seeking current income alongside potential appreciation.

Bond or Fixed Income Funds

Hold $5.1 trillion in assets. These funds invest in debt securities and typically offer more stable income and lower volatility than stock funds, though they're sensitive to interest rate changes. When rates rise, bond prices fall, and vice versa.

You'll encounter:

• Government bond funds (Treasury securities backed by the U.S. government).
• Corporate bond funds (debt issued by companies, offering higher yields but credit risk).
• Municipal bond funds (state and local government debt, often providing tax-exempt interest for investors in high tax brackets).

Bond funds vary by credit quality (investment-grade vs. high-yield) and duration (short-term, intermediate, long-term).

Hybrid or Balanced Funds

Manage $1.64 trillion in assets. These funds combine stocks and bonds in a single portfolio, typically using allocations like 60% stocks and 40% bonds to balance growth potential with income stability.

They're designed for investors who want diversification across asset classes without managing multiple funds.

Money Market Funds

Hold $6.88 trillion in assets. These funds invest in short-term, high-quality debt securities like Treasury bills, commercial paper, and certificates of deposit.

They aim to maintain a stable $1.00 NAV and provide liquidity similar to a savings account. Returns are modest but the risk is very low, making money market funds suitable for emergency funds or cash you'll need within months.

Target-Date Funds

Are designed for retirement planning. Each fund targets a specific retirement year (like Target Date 2050 or Target Date 2035).

The fund automatically shifts from an aggressive, stock-heavy allocation when you're young to a conservative, bond-heavy allocation as you approach the target date. This 'glide path' reduces risk as you near retirement, eliminating the need for you to manually rebalance over decades.

Index Funds

Represent a distinct management approach rather than an asset class. These funds passively track specific market indices like the S&P 500, Russell 2000, or Bloomberg U.S.

Instead of trying to beat the market through active security selection, index funds simply replicate the index's holdings.

This passive strategy results in significantly lower fees (average 0.14% for index equity funds vs. 0.40% for actively managed equity funds) because there's minimal research, trading, or manager compensation involved.

Index funds have gained enormous popularity as evidence mounts that most active managers fail to consistently outperform their benchmarks over long periods.

Understanding mutual fund costs is critical because fees directly reduce your returns, and seemingly small differences compound dramatically over decades.

Expense Ratios

Expense ratios represent annual operating costs expressed as a percentage of assets. These costs include:

• Management fees (compensation for the fund manager and research team).
• Administrative expenses (recordkeeping, customer service).
• Acounting and legal fees.
• 12b-1 distribution fees (marketing and distribution costs).

As of 2025, average expense ratios are 0.40% for equity funds, 0.38% for bond funds, and 0.22% for money market funds, according to the Investment Company Institute's data. These figures represent dramatic declines from historical levels. Equity fund expense ratios have fallen 62% since 1996, driven by competition and the growth of low-cost index funds.

Expense ratios are deducted from fund assets automatically, reducing returns indirectly rather than appearing as separate charges on your statement.

Sales Loads

Sales loads are commissions paid when buying or selling fund shares. Front-end loads are charged at purchase, typically 3% to 5.75%, reducing your initial investment. If you invest $10,000 in a fund with a 5% front-end load, only $9,500 actually goes to work for you. The other $500 goes to the broker or advisor who sold you the fund.

Back-end loads (also called deferred sales charges or contingent deferred sales charges) are charged when you redeem shares, usually declining over time on a schedule like 5% in year one, 4% in year two, 3% in year three, eventually disappearing after five to seven years.

No-load funds charge no sales commissions and represented 92% of mutual fund sales in 2025. By law, combined front-end and back-end loads cannot exceed 8.5%.

12b-1 Fees

12b-1 fees are ongoing distribution and marketing expenses, named after the SEC rule that permits them.

These fees are included in the expense ratio and capped at 0.25% annually for funds calling themselves 'no-load.' Funds charging more than 0.25% in 12b-1 fees cannot use the no-load designation.

Redemption or Exit Fees

Exit fees are charges for selling shares within specified periods, typically 0.5% to 2%. These fees discourage short-term trading that can disrupt fund management and hurt long-term shareholders.

Redemption fees are paid to the fund itself (benefiting remaining shareholders) rather than to brokers, distinguishing them from back-end loads.

Share Classes

Represent different fee structures for the same underlying portfolio:

• Class A shares typically carry front-end loads but lower ongoing expense ratios, making them more economical for large investments or long holding periods.
• Class B shares usually have back-end loads and higher ongoing expenses, converting to Class A shares after a specified period.
• Class C shares charge level loads (ongoing fees instead of upfront or deferred charges) and have the highest ongoing expense ratios, making them suitable only for very short holding periods.
• Institutional share classes offer the lowest expense ratios but require high minimums, typically $100,000 or more.

The bottom line: investors should carefully compare total costs across funds and strongly consider no-load, low-expense-ratio options, particularly index funds. The shift toward low-cost, no-load funds has saved investors billions and represents one of the most positive trends in the asset management industry.

Active mutual funds employ managers who make discretionary decisions about which securities to buy and sell, attempting to outperform a benchmark index through research, analysis, and market timing.

These funds charge higher expense ratios (averaging 0.40% to 0.70%) to cover the costs of research teams, frequent trading, and manager compensation. The goal is to beat the market, but the reality is that most active managers fail to do so consistently over long periods.

According to S&P Dow Jones Indices SPIVA reports, over 80% of active large-cap equity fund managers underperformed the S&P 500 over 10-year periods.

Passive mutual funds (or index funds) simply replicate the holdings of a specific market index like the S&P 500 or Russell 2000. There's no attempt to beat the market, only to match it.

This approach requires minimal research, infrequent trading, and no high-priced star managers, resulting in dramatically lower expense ratios (averaging 0.14% for index equity funds).

Over decades, the lower costs and consistent market-matching returns of passive funds typically produce better outcomes than most active alternatives.

The active vs. passive debate is one of the most important decisions you'll make as an investor, and we'll cover it in depth in a separate article dedicated to this topic.

Mutual funds serve several essential purposes that make them valuable tools for individual investors.

Instant Diversification

Diversification is perhaps the most fundamental benefit. A single mutual fund investment provides exposure to dozens, hundreds, or even thousands of individual securities. This spreads risk in a way that would be impossible or prohibitively expensive for most individual investors to replicate.

If you tried to build a diversified portfolio by buying individual stocks, you'd need substantial capital to purchase meaningful positions in 50 or 100 companies, plus you'd pay trading commissions on each transaction.

A mutual fund does this for you with a single purchase. Diversification reduces the impact of any single security's poor performance on your overall portfolio. When one stock in the fund declines, others may maintain value or appreciate, offsetting losses.

Professional Management

Fund's management gives you access to expertise you likely don't possess. Managers and their research teams have the knowledge, technology, and resources to analyze securities, evaluate market conditions, and make informed decisions about what to buy, when to buy, what to sell, and when to sell.

They monitor economic indicators, company earnings, industry trends, and countless other factors. For investors without time or knowledge to research individual securities, professional management provides value despite the fees it entails.

Accessibility and Convenience

Mutual funds democratize investing. Most mutual funds have relatively low minimum investments, typically $100 to $3,000, though some require even less or waive minimums for automatic investment plans.

You don't need $100,000 to access professional management anymore. The purchase process is simple: you can buy directly from fund companies, through online brokers, or via financial advisors. Once you've invested, there's minimal ongoing involvement required. You don't need to research individual securities, execute trades, or monitor positions daily. The fund handles everything.

Liquidity

Liquidity means you can access your money when you need it. Open-end mutual funds allow daily redemption at NAV. You don't need to find a buyer in a secondary market or worry about whether you can sell at a reasonable price.

Submit a redemption request, and you'll receive the current day's NAV (if submitted before the cutoff, typically 4:00 p.m. ET) or the next day's NAV. Your proceeds typically arrive within one to three business days.

Retirement Planning

Represents a major use case. Mutual funds serve as the primary investment vehicle in 401(k) plans and IRAs, helping millions of Americans build retirement savings.

Employer-sponsored plans typically offer a menu of mutual funds covering different asset classes and risk levels, allowing employees to construct diversified portfolios aligned with their retirement timelines.

Automatic Investing

Makes wealth-building systematic. Many funds offer systematic investment plans (SIPs) enabling regular contributions directly from your bank account.

This implements dollar-cost averaging: you purchase more shares when prices are low and fewer shares when prices are high, averaging out your cost over time and eliminating the need to time the market. Automatic investing turns saving into a habit rather than a monthly decision.

Mutual funds serve investors who want professionally managed, diversified portfolios without the complexity of selecting and monitoring individual securities. They're tools for people who recognize that building wealth requires participating in financial markets but who don't have the time, knowledge, or inclination to become security analysts themselves.

Despite their benefits, mutual funds carry meaningful risks and limitations you need to understand.

Market Risk

Mutual funds carry the same market risk as their underlying securities. Stock fund values fluctuate with equity markets, bond fund values fluctuate with interest rates and credit conditions, and you can lose some or all of your principal if markets decline.

The 2008-2009 financial crisis saw many equity funds lose 40% to 50% of their value. The 2000-2002 bear market was similarly brutal. Past performance doesn't predict future results, and higher potential returns correlate directly with higher loss risk.

A fund that gained 20% last year could lose 20% next year. There's no guarantee you'll make money or even preserve your principal.

Fees and Expenses

These costs directly reduce your returns, and the impact compounds dramatically over decades.

A seemingly small 1% expense ratio costs $10 annually per $1,000 invested, but over 30 years, it can reduce your ending wealth by 20% or more compared to minimal-expense alternatives.

Sales loads are even more damaging. A 5% front-end load means 5% of your money never gets invested. If you invest $20,000, only $19,000 goes to work for you, and you'll need an 11% gain just to break even (not a 5% gain, because you're recovering $1000 on a $19,000 investment). High fees are one of the most predictable drags on long-term wealth accumulation.

Tax Inefficiency

Affects taxable accounts (though not retirement accounts like 401(k)s or IRAs).

Mutual funds must distribute capital gains to shareholders when managers sell appreciated securities, creating tax obligations even if you didn't sell any shares and even if your overall investment shows unrealized losses.

Here's how this plays out:

• The fund manager sells stock that gained 50%, realizes a capital gain, and distributes it to all shareholders.
• You owe taxes on that distribution regardless of whether you reinvested it or took it as cash, and regardless of whether other holdings in the fund declined.
• Active management exacerbates this problem through frequent trading that generates higher capital gains distributions.

Passive index funds typically generate fewer taxable events because they trade infrequently.

Manager Risk

We counted this as an advantage as well, but it can also be a disadvantage, if you think about it, because your returns depend on someone else's skill.

Actively managed funds rely on manager decision-making, and poor choices can generate below-benchmark returns despite ongoing management fees. The performance reality is sobering, and more and more studies are showing this: according to The White Coat Investors' data, only 1 in 20 managers were able to beat the S&P 500 over 10-year periods.

In other words, you're paying higher fees for expertise that usually fails to deliver outperformance. Even managers with strong track records can experience periods of underperformance or leave the fund, leaving you with a new, unproven manager.

Lack of Control

You cannot customize portfolios to personal preferences, tax situations, or ethical considerations (unless you choose specialized funds). If the fund holds a company you find objectionable, you're stuck with it.

You cannot harvest tax losses on individual positions or time purchases and sales of specific securities. You must accept the manager's decisions.

No Intraday Trading

Funds price once daily at NAV after market close at 4:00 p.m. ET. You cannot respond to intraday market movements, news events, or price changes.

If you submit a purchase order at 10:00 a.m. and markets rally 2% by close, you'll pay the higher closing NAV. If you submit a redemption order at 10:00 a.m. and markets fall 2% by close, you'll receive the lower closing NAV.

For long-term investors, this rarely matters, but it's a limitation compared to continuously traded securities.

Minimum Investments

While many funds have minimums of $1,000 to $3,000, some require $10,000, $25,000, or more. These minimums can prevent diversification across multiple funds if you're starting with limited capital.

Cash Drag

Cash drag occurs because funds must maintain cash reserves to meet redemptions. If markets are rising and the fund holds 3% to 5% in cash, that cash earns minimal returns while stocks are appreciating, creating performance drag. Over long periods, this can cost 0.25% to 0.50% in annual returns.

Mutual funds remain one of America's most popular investment vehicles for good reasons:

• They provide instant diversification, professional management, convenient access, and regulatory protections that have helped over 53.7% of U.S. households (71 million households) build wealth for retirement and other financial goals.
• For most people, particularly those in employer-sponsored retirement plans or building long-term wealth without time or expertise for individual security selection, mutual funds represent practical, accessible tools for participating in financial markets.

That said, mutual funds aren't perfect:

• They carry market risk, meaning you can lose money when markets decline.
• They charge ongoing fees that directly reduce your returns, and those fees compound over decades into significant sums.
• Many actively managed funds underperform their benchmarks despite charging higher fees.
• In taxable accounts, mutual funds can create tax inefficiency through capital gains distributions you can't control.
• You lack control over specific securities and cannot trade intraday.

The key to successful mutual fund investing involves several principles:

• First, understand your investment objectives, risk tolerance, and time horizon. A 25-year-old saving for retirement can tolerate more volatility than a 60-year-old needing income.
• Second, carefully compare expense ratios and avoid high-cost funds when low-cost alternatives exist. The difference between a 0.10% expense ratio and a 1.00% expense ratio can cost you 20% or more of your ending wealth over 30 years.
• Third, strongly consider passive index funds for efficient markets like U.S. large-cap stocks, where most active managers fail to add value after fees.
• Fourth, diversify across asset classes and fund types rather than concentrating in a single fund or sector.
• Fifth, take advantage of tax-advantaged accounts like 401(k)s and IRAs where possible, as they eliminate the tax inefficiency problem.
• Sixth, maintain a long-term perspective and avoid emotional reactions to short-term volatility. Markets fluctuate, but historically they've rewarded patient investors who stayed invested through ups and downs.
• Seventh, read fund prospectuses to understand objectives, strategies, risks, and fees before investing.

Understanding mutual fund basics empowers you to make informed decisions aligned with your financial goals. You don't need to become an investment expert, but you do need to understand how these tools work, what they cost, and how they fit into your overall financial plan.

The combination of diversification, professional management, and accessibility has made mutual funds effective wealth-building tools for millions of Americans. With realistic expectations and disciplined implementation, they can serve you well too.