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What Are Mutual Funds?

We break down the basics of one of the most common investment vehicles for new investors.

Editor’s note: This article originally ran on Oct. 12, 2020.

What Are Mutual Funds?

Mutual funds are one of the most common investments for new investors building portfolios and are often a staple in employer-sponsored retirement plans, such as 401(k)s. Mutual funds are financial vehicles made up of a pool of money collected from many investors to invest in a variety of securities, including stocks, bonds, money market instruments, and other assets. Because mutual funds diversify investments among a number of securities, they provide instant diversification and are therefore less risky than holding an individual security, such as single stock.

Many mutual funds require investors to make a minimum investment. These minimums differ based on whether someone is investing through a No Transaction Fee network, investing in an IRA, or signing up for an automatic investment plan, like a 401(k).

Is a mutual fund the right investment for you? Here is what you need to know.

How Do Mutual Funds Work?

Investors who do not have a lot of financial experience or a lot of time and interest to assemble and monitor a basket of stocks or bonds on their own find themselves at the same place, wondering where they should invest. Mutual funds are popular options for investors in this position because they are professionally managed. This means that one or more appointed individuals are supported by a research team to manage the fund. The fund managers do the individual security selection for you.

Types of Mutual Funds

When investors choose a mutual fund, they do not directly own the underlying holdings that make up the fund. Rather, they are shareholders of the mutual fund, not each security or asset that makes up the fund.

For example, let's say you choose to invest in Vanguard Institutional Index VINIX. Although you are an investor in this fund, you are not a shareholder of Apple AAPL, and you cannot vote at Apple's annual meetings.

Because there are a variety securities that mutual funds can invest in, there are several different types of mutual funds. Some of the most common types include:

The Costs of Mutual Funds

Like all investments, mutual funds come with a price tag. Shareholders pay ongoing fees and expenses for owning a mutual fund. There are a variety of costs, such as:

  • Annual operating expenses: These ongoing expenses pay the fund managers, their research teams, and everyone else who works for the mutual fund. These may include management fees and 12b-1 fees, which pay for the cost of marketing and selling the fund.
  • Sales fees: These fees include sales commissions and the one-time costs to buy or sell mutual fund shares. The commissions are also known as “loads” and are paid to the salesperson selling the fund. Investors will encounter these fees if they buy a mutual fund through a financial intermediary, such as a commercial bank or an investment bank. Mutual funds that are bought directly from fund companies or an NTF network do not have these transaction fees.
  • Redemption charge: This is a penalty if a shareholder sells mutual fund shares too soon. Not every fund does this, but the charge typically occurs when shares are sold before a designated time period has passed. Mutual funds are not exactly designed for short-term trading. They are normally a part of long-term investment strategies.

The Decision

Is a mutual fund the right investment for you? Before answering that question, there are some things you need to consider first. Why are you investing? Before buying shares in a mutual fund or any other investment, you need to establish why you are investing in the first place. If you are investing for retirement or if you are investing to buy a home, your investment needs and strategies for both are going to look very different. Start off by calculating how much time you have and how much risk you can afford. Use these resources to help determine your investing goals:

Although mutual funds are a popular choice, that doesn't mean they are the only choice. Consider all your investment options and explore the ins and outs of other investment vehicles:

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