Mutual Funds Basics

Mutual funds are one of the oldest and most widely used ways to invest. Instead of picking individual stocks or bonds on your own, you buy units of a fund that holds many different investments. A professional manager (or a rules-based process) decides what the fund owns, and you share in the gains and losses.

This page explains how mutual funds work in plain language: what you are actually buying, the main types of funds, how fees are charged, and how to think about mutual funds inside a broader investing plan.

What you own when you buy a mutual fund

A mutual fund is a pooled investment vehicle. Many investors put their money into the same fund, and the fund company uses that pool of money to buy securities:

• Stocks
• Bonds
• Cash and short-term instruments
• Sometimes real estate, commodities or other assets

In exchange, you receive units or shares of the fund. Each unit represents a slice of everything the fund owns. The value of a unit is called the net asset value (NAV). It goes up and down with the value of the underlying holdings, minus fees and expenses.

How mutual funds are priced and traded

Unlike individual stocks or most exchange-traded funds (ETFs), traditional mutual funds do not trade all day on an exchange. Instead:

• Orders to buy or sell are collected during the day.
• At the end of the day, the fund calculates its NAV.
• All orders are executed at that single end-of-day price.

This is why you often see mutual funds quoted with one price per day, rather than a constantly changing ticker during market hours.

Common types of mutual funds

There are thousands of mutual funds, but most fall into a few broad categories:

• Equity funds: invest mainly in stocks. They may focus on large companies, small companies, growth stocks, value stocks or specific sectors.
• Bond (fixed-income) funds: invest in government and corporate bonds. They aim to provide income and lower volatility than stocks.
• Balanced or asset-allocation funds: hold a mix of stocks and bonds in one product, designed as an all-in-one portfolio.
• Money market funds: hold very short-term, high-quality instruments and aim to preserve capital while providing modest interest.
• Index funds: track a specific market index rather than trying to beat it. Many index funds are now offered as ETFs as well.

When you compare funds, look not just at the name, but at the investment objective and what the fund is allowed to own.

How mutual fund fees work

Mutual funds charge ongoing fees to cover management, administration and distribution costs. The most important cost measure is the management expense ratio (MER) or total expense ratio (TER). This is usually quoted as a percentage per year.

For example, if a fund has an MER of 2% per year and the underlying investments returned 7%, a typical investor might see roughly 5% after fees (before taxes). Over long periods, high fees can significantly reduce your ending portfolio value.

In addition to MERs, some mutual funds charge:

• Front-end loads: a sales commission when you buy.
• Back-end loads or deferred sales charges: a fee if you sell within a certain period.
• Performance fees: extra charges if the fund beats a benchmark (more common in specialised strategies).

Many investors now prefer no-load funds and low-fee index-style products, because costs are one of the few things you can control.

Active vs. index (passive) mutual funds

Mutual funds can be managed in two main ways:

• Active management: a manager or team selects securities in an effort to beat a benchmark index. Fees are usually higher.
• Index or passive management: the fund simply tracks a benchmark, such as the S&P 500. Fees are usually lower, and there is no attempt to “outsmart” the market.

Many studies show that, after fees, a large portion of active funds fail to beat their benchmarks over long periods. This is one reason why index funds and ETFs have grown so quickly in recent years.

Where mutual funds fit in a portfolio

Mutual funds can make sense for investors who:

• Prefer to delegate security selection to a professional manager.
• Want instant diversification with one purchase.
• Are investing smaller amounts on a regular schedule.
• Have access to low-fee funds through a retirement plan or brokerage platform.

In practice, some investors combine mutual funds with individual stocks, bonds or options and futures for more advanced strategies. Others keep things simple and use a small number of broad, low-cost funds.

Pros and cons of mutual funds

Advantages:

• Easy to buy and sell through many banks and brokers.
• Built-in diversification, even with small amounts of money.
• Professional management and research.
• Automatic reinvestment options for dividends and distributions.

Disadvantages:

• Fees can be high, especially for actively managed funds with sales loads.
• Less intraday flexibility than ETFs, since trades execute at end-of-day NAV.
• Performance may lag simple low-cost index strategies after fees.
• Some funds use complex strategies that are hard for investors to evaluate.

Questions to ask before buying a mutual fund

• What is the fund's investment objective and benchmark?
• What are the total fees (MER/TER, loads, trading costs)?
• How long is my time horizon for this investment?
• How does this fund fit with what I already own?
• Am I comfortable with the level of risk and volatility?

For a more complete picture of how mutual funds compare to other choices, you may also want to review our pages on bonds, options, futures and day trading.