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, how mutual funds compare to ETFs, 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.

When you invest in a mutual fund, you are not lending the fund money like a bondholder, and you are not buying the fund company itself. You are buying a proportional claim on the underlying portfolio that the fund holds.

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 by the fund company or broker.
• At the end of the day, the fund calculates its NAV based on the closing prices of its holdings.
• 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. It also means you do not know the exact price you will get when you place an order earlier in the day.

Dividends and distributions

Mutual funds may receive dividends from stocks and interest from bonds. They also realise capital gains when they sell securities at a profit. These amounts can be:

• Paid out to you as cash distributions, or
• Automatically reinvested in more units of the fund.

The fund will typically provide a summary of distributions each year, showing how much came from income and how much came from capital gains. In taxable accounts, this matters for how your returns are taxed.

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 such as technology or healthcare.
• Bond (fixed-income) funds: invest in government and corporate bonds. They aim to provide income and lower volatility than stocks. For more on bonds themselves, see our page on bonds.
• Balanced or asset-allocation funds: hold a mix of stocks and bonds in one product, often marketed as an all-in-one portfolio solution.
• 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.
• Sector and specialty funds: focus on narrower themes such as real estate, commodities, technology or emerging markets.
• Target-date funds: adjust their mix of stocks and bonds automatically over time based on a target retirement year.

When you compare funds, look not just at the name, but at the investment objective, what the fund is allowed to own, and how it has behaved in different market environments.

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, apparently small differences in 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 directly control. When comparing mutual funds, always check both the MER and any sales charges or account-level fees that might apply.

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, and results may differ significantly from the benchmark.
• Index or passive management: the fund simply tracks a benchmark, such as a broad stock index. Fees are usually lower, and the goal is to match the index before costs.

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. However, some investors still choose active funds in areas where they believe skilled managers may add value.

Mutual funds vs. ETFs

Mutual funds and exchange-traded funds (ETFs) often hold similar portfolios, but they differ in how they trade and how investors use them.

Mutual funds:

• Trade once per day at end-of-day NAV.
• Often used in workplace retirement plans and automatic contribution programs.
• Minimum initial investment amounts may apply.
• Some offer automatic purchase and withdrawal plans.

ETFs:

• Trade throughout the day on an exchange, like stocks.
• Prices can fluctuate above or below underlying NAV during the day.
• Often have very low expense ratios, especially for index ETFs.
• May involve brokerage commissions, depending on the platform.

In practice, many investors use both mutual funds and ETFs. The right choice depends on your platform, contribution habits, trading costs and comfort with placing orders during the trading day.

Where mutual funds fit in a portfolio

Mutual funds can make sense for investors who:

• Prefer to delegate security selection to a professional manager or index provider.
• 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 as the core of a long-term retirement portfolio.

How to choose a mutual fund

When you compare mutual funds, consider the following questions:

1. What is the fund’s objective? Is it trying to provide growth, income, or a combination of both? What benchmark does it use?
2. What are the total fees? Look at the MER/TER, any sales loads and any account-level fees at your platform.
3. What does the fund actually hold? Review the top holdings, sector breakdown and geographic exposure to make sure it fits your risk tolerance.
4. How has it behaved in different markets? Past performance does not guarantee future results, but it can show how the fund reacts in up and down markets.
5. How does it fit with what you already own? Avoid unnecessary overlap if multiple funds hold similar securities.

Common mistakes with mutual funds

Even simple products can be misused. Common pitfalls include:

• Chasing recent performance: buying last year’s top-performing fund without understanding its strategy or risk level.
• Ignoring fees: focusing only on past returns and not on how much of those returns are kept after ongoing costs.
• Owning too many funds: holding a long list of overlapping funds that together behave like a single index, but with higher fees.
• Mixing strategies without a plan: combining aggressive sector funds with cautious bond funds without an overall asset-allocation framework.

A clear investment plan, realistic time horizon and attention to costs can help mutual funds serve their intended role: providing diversified exposure to markets in a manageable way.

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?
• Is there a lower-cost index fund or ETF that offers similar exposure?

For a more complete picture of how mutual funds compare to other choices, you may also want to review our pages on bonds, day trading, options and futures. To learn more about opening accounts and platforms, see stock trading sites, and for quick definitions of terms like MER, NAV and volatility, visit our Dictionary Index.

Mutual funds FAQ