What is a Mutual Fund? And Why Are They So Popular?

According to the Investment Company Institute, 44.5% of all U.S. households owned mutual funds in 2017. So what is a mutual fund, and why are they so popular?
Last updated Jun 19, 2020 | By Matt Miczulski
Puzzled man

FinanceBuzz is reader-supported. We may receive compensation from the products and services mentioned in this story, but the opinions are the author's own. Compensation may impact where offers appear. We have not included all available products or offers. Learn more about how we make money and our editorial policies.

Getting started with investing can seem like a daunting task. What type of investment account do you need? How much money does it take to get started?

There are thousands of companies you can invest in, and then you have to decide what types of assets you want to add to your portfolio. Will you invest in stocks, bonds, or real estate? Or do you want a diversified portfolio made up of investments from all the different asset classes?

Investing in mutual funds is a simple answer to these questions, though they may not be right for everyone. So what in the world is a mutual fund?

If you’re interested in learning more about mutual funds, we’re here to explain the basics and answer your questions.

Jump To

What is a mutual fund?

A mutual fund is a professionally managed investment fund that pools money from a large number of investors to buy a variety of securities, such as stocks, bonds, money market instruments (e.g., treasury bills), or other securities. When you buy a share in a mutual fund, you own a portion of all the investments in that fund.

Mutual funds are open-end investment funds, which means they can issue unlimited new shares. In other words, shares are issued as long as there are investors interested in the fund. If you choose to sell your fund shares, you sell them back at their current value, minus any fees.

If you’re a beginner investor or prefer to take a hands-off approach, it’s worth considering how mutual fund shares can help you reach your investment goals. There are several types of mutual funds, but only four that stand out among the rest.

4 common types of mutual funds

  • Stock funds
  • Bond funds
  • Money market funds
  • Target date funds

Many different types of mutual funds exist across different asset classes. Asset classes are groups of similar types of investments, such as stocks, bonds, and money market instruments.

Here are the four most common types of mutual funds:

1. Stock funds

Stock funds, or equity funds, invest primarily in common stocks (equities) of publicly-traded companies. According to the Investment Company Institute, stock funds made up more than half (53%) of all mutual funds in 2019. The type of stocks in which a stock fund will invest depends on the objectives of the fund. For example, one fund's portfolio may include newer, smaller companies (small-cap) that have a smaller market capitalization. In contrast, another portfolio of stocks may include more established, well-known companies (large-cap) that have a higher market capitalization and pay regular dividends. Market capitalization is the total value of a company in the stock market determined by multiplying a stock’s current share price by the number of shares outstanding.

Stock funds based on company size

  • Large-cap: Companies with a market capitalization of more than $10 billion
  • Mid-cap: Companies with a market capitalization between $2 billion and $10 billion
  • Small-cap: Companies with a market capitalization between $300 million and $2 billion

Growth funds

Growth funds are made up of stocks expected to grow faster than other stocks, with little or no dividend payments.

Income funds

Income funds are a type of stock fund whose goal is to provide an income from investments. Income funds consist of stocks that pay regular dividends. A dividend is a payment paid to shareholders that represent a portion of the company’s profits. You can think of it as passive income.

Sector funds

Sector funds are made up of stocks within a specific industry sector. Industry sectors include technology, finance, and natural resources, among many others.

Index funds

The goal of an index fund is to replicate the performance of a particular market index such as the S&P 500. Index fund portfolio managers typically take a more passive approach because the fund lends itself to a buy-and-hold strategy instead of frequent trading. This usually results in lower fees and expenses compared to a fund that is actively managed.

2. Bond funds

A bond fund, also known as a fixed income mutual fund, is a type of mutual fund that is made up of bonds and other types of debt securities, such as government bonds, municipal bonds, and mortgage-backed securities. The type of bond or debt security that bond fund managers invest in depends on their goals and objectives. For this reason, fixed-income funds will vary in terms of risk, return, duration, and volatility.

3. Money market funds

Money market funds are a type of mutual fund that’s made up of high-quality, short-term debt. This includes debt securities issued by U.S. corporations, as well as federal, state, and local governments. Money market funds have relatively low risk because, by law, their managers must invest only in certain high-quality investments.

4. Target date funds

Target date funds are designed for people with particular retirement dates in mind. These funds are made up of a mix of stocks, bonds, and other investments, and this mix gradually shifts over time according to the fund’s strategy. This prevents you from having to manually change your investment mix or asset allocation. For example, a target date fund might start out with a greater portion of stocks compared to bonds and take on a more aggressive investing style. As you approach the target date and your risk tolerance decreases, the fund automatically adjusts to become more conservative.

Other types of mutual funds

Balanced/hybrid funds

Balanced funds, also known as hybrid funds, are made up of a mix of stocks, bonds, and sometimes money market components in a single fund. For this reason, balanced funds provide diversification in a portfolio.

International funds

International funds can provide even greater diversification to your portfolio by allowing you to invest in non-U.S. companies. These funds are made up of foreign securities such as stocks and bonds, helping you take advantage of opportunities from around the globe.

Mutual fund pros and cons

Investing in mutual funds comes with several advantages, but they have some disadvantages as well. Here are some of the pros and cons of investing in mutual funds:

Mutual fund advantages

  • Diversification: Buying a share in a mutual fund allows you to own a share of all the different investments within the fund. A single mutual fund by itself provides a degree of diversification, but investing in several mutual funds across different asset classes and sectors gives your portfolio broader exposure to the market.
  • Professional management: Whether active or passive, mutual funds come with a professional money manager. They make decisions on how to invest your money based on research and their overall strategy. If you have no desire to learn how to invest and prefer the advice and expertise of a professional, a mutual fund might be a good option for you.
  • Accessibility: Whether your investment portfolio is through an employer-sponsored retirement plan or you manage your investments yourself with a brokerage account, mutual funds are easily accessible. You can also buy mutual funds directly from the company that created the fund, such as Fidelity, Vanguard, or BlackRock.

Mutual fund disadvantages

  • Costs: Although a professionally managed fund has its benefits, it also comes with higher costs than if you were to build your own portfolio with your own choice of investments. The fees associated with ongoing management, also known as the mutual fund expense ratio, will vary based on the type of fund and how it’s managed. For instance, front-end load and back-end load mutual funds both come with sales fees when an investor buys or sells their shares. Although you won't need to worry about a sales commission fee with a no-load mutual fund, you may incur higher fees elsewhere. The average expense ratio for an actively managed mutual fund was .74% in 2019, according to the ICI. You could invest in an index fund at a fraction of the cost — .07% on average in 2019.
  • Lack of ownership: Investing in a mutual fund means you own a share of the fund, not the individual stock within the stock fund. If you’re more interested in owning a share of Apple and have voting rights in the company, you’re better off buying the stock itself.
  • Lack of control: Investors that prefer to be hands-on with their investing probably won’t find much appeal in mutual funds. Although you get to choose the mutual fund to invest in, you don’t get to choose the investments within the fund itself.

Mutual funds vs. ETFs: How do they compare?

Mutual funds and exchange-traded funds (ETFs) share many similarities, though they have differences that may make one option more preferable than the other.

As with mutual funds, ETFs pool money from many investors to purchase stocks, bonds, or other assets. And when you buy a share of an ETF, you receive an interest in the fund. Most ETFs are professionally managed, whether it’s a passively managed fund that seeks to replicate the return of a market index or an actively managed fund that buys and sells investments according to the fund’s objectives.

Unlike mutual funds, which are sold directly to investors and only trade once per day at the close of the market at its net asset value per share, ETFs can be traded throughout the day on national stock exchanges at market prices. NAV is equal to the company’s total assets minus its total liabilities. Because you can buy an ETF for the price of one share — that is, the ETF’s market price — ETFs tend to be more suitable for those who prefer lower investment minimums. Mutual fund minimum investments are a flat dollar amount, with some costing several thousands of dollars.

Taxes on mutual funds and ETFs vary depending on the fund and its investments. In other words, a fund made up of stocks that pay regular dividends might have different tax implications than a stock fund that doesn’t distribute dividends. However, in general, when you sell shares of mutual funds or ETFs for a profit, you will owe taxes on the realized capital gain.

FAQs about mutual funds

How does a mutual fund work?

A mutual fund works by pooling money from many individual investors to buy stocks, bonds, and other securities. When you buy a share in a mutual fund, you own a portion of all the investments within that fund.

Are mutual funds a good investment?

Investing in a mutual fund could be a good way to make a diversified investment, as it allows you to own a portion of all the different investments within the fund. Investing in several mutual funds across different asset classes and sectors will provide you with an even more diversified portfolio. Whether this investment strategy is right for you depends on your needs and investment objectives. Remember all investments come with risk.

What is a mutual fund expense ratio?

A mutual fund expense ratio is the annual fee the fund charges its shareholders. It’s the fund’s total operating expenses for the year, including management fees, sales load, administrative fees, and other fees. An expense ratio is expressed as a percentage by dividing the fund’s expenses by the fund’s assets.

How do beginners invest in mutual funds?

You can get started investing in mutual funds in several ways. If you contribute to an employer-sponsored retirement account such as a 401(k), you may already be investing in mutual funds. If not, look into what types of mutual funds your plan offers by contacting your plan administrator. Outside of a retirement plan, you can invest in mutual funds with an individual brokerage account. You will likely have access to a wider variety of mutual funds this way, so compare affordability and fund choices before investing.

How do you make money in a mutual fund?

You can make money three ways with a mutual fund: income earned from dividend payments; capital gains from selling a security that has increased in price; the value of the fund increases, which increases the value of the shares (NAV). You would then make money should you decide to sell your shares at this increased price.

Are ETFs better than mutual funds?

Exchange-traded funds (ETFs) and mutual funds share many similarities. Both funds consist of pooled money from many investors and a variety of securities, and both are professionally managed. ETFs, however, are usually a less expensive investment because they tend to be passively managed instead of actively managed. Whether one is better than the other depends on your investment strategy.

Investing in mutual funds: how to start

If mutual funds sound like the right type of investment for you, rest assured that it’s easy to start investing in them. As mentioned before, mutual funds are easily accessible. They can be purchased in any investment account, such as a 401(k), IRA, or brokerage account. Before you invest in a mutual fund, read the fund’s prospectus so you understand the fees and investing strategy.

If you’re ready to start investing, check out our picks for the best investment apps