What Is a Mutual Fund?
A mutual fund is a type of investment vehicle that pools money from many investors to invest in a diversified portfolio of securities, such as stocks, bonds, and other assets. Managed by professional investment advisers, these funds offer individuals a way to invest in a broad range of assets without having to buy and sell individual securities themselves. Each share of a mutual fund represents a proportional ownership in the fund's underlying assets, and its value fluctuates based on the performance of those assets.
History and Origin
The concept of pooled investments can be traced back to the Netherlands in the late 18th century, but modern mutual funds as we know them gained significant traction in the United States in the early 20th century. The first open-end investment company, Massachusetts Investors Trust, was founded in 1924, allowing investors to buy and sell shares daily directly from the fund. The growth of the industry necessitated regulation, leading to the enactment of the Investment Company Act of 1940. This landmark legislation established a framework for the regulation of investment companies, including mutual funds, and imposed requirements regarding disclosure, operations, and governance to protect investors.13 This act requires these companies to disclose their financial condition and investment policies to investors when shares are initially sold and on a regular basis thereafter.12
Key Takeaways
- A mutual fund pools money from multiple investors to invest in a diversified portfolio of securities.
- Professional fund managers oversee the investment decisions and manage the fund's portfolio.
- Mutual funds offer investors potential diversification and professional management, which can be advantageous over purchasing individual securities.11
- Investors purchase shares of a mutual fund, and the value of these shares is based on the fund's net asset value (NAV).
- All mutual funds incur fees and expenses, which can impact overall returns.10
Formula and Calculation
The most common calculation associated with a mutual fund is its Net Asset Value (NAV). The NAV represents the per-share value of a mutual fund and is calculated at the end of each trading day.
The formula for calculating NAV is:
Where:
- Total Assets: The market value of all the securities and other assets held by the fund.
- Total Liabilities: All the fund's debts, expenses, and other obligations.
- Total Number of Shares Outstanding: The total number of shares of the mutual fund currently held by investors.
This calculation determines the price at which investors can buy or sell shares of the mutual fund on a given day.
Interpreting the Mutual Fund
Understanding a mutual fund involves evaluating several factors beyond just its historical performance. The fund's expense ratio is a critical metric, representing the annual cost of operating the fund as a percentage of its assets. A lower expense ratio generally means more of an investor's money is working for them. Investors should also review the fund's investment objective to ensure it aligns with their financial goals, whether that's growth, income, or a blend of both. Additionally, examining the fund's specific holdings and its approach, such as whether it employs active management or is an index fund, provides insight into its risk profile and potential returns. Resources like Morningstar provide comprehensive data and ratings to help investors evaluate mutual funds effectively.9,8
Hypothetical Example
Consider an investor, Sarah, who wants to diversify her holdings but has limited capital. Instead of buying individual stocks and bonds, she decides to invest in a balanced mutual fund. The fund's portfolio consists of 60% stocks and 40% bonds.
Let's assume the mutual fund has:
- Total Assets = $100,000,000
- Total Liabilities = $5,000,000
- Total Number of Shares Outstanding = 5,000,000 shares
Using the NAV formula:
If Sarah invests $1,900, she would purchase 100 shares of the mutual fund at $19.00 per share. As the underlying stocks and bonds in the fund's portfolio fluctuate in value, so too will the fund's NAV, impacting the value of Sarah's investment. She may also receive dividends or capital gains distributions from the fund.
Practical Applications
Mutual funds are widely used in various aspects of financial planning and investing due to their accessibility and structure. They are a common component of retirement accounts such as 401(k)s and Individual Retirement Accounts (IRAs), allowing individuals to build diversified retirement portfolios. Mutual funds also feature prominently in educational savings plans and other long-term investment strategies. Investors often choose them for their built-in diversification, which helps spread risk across numerous securities, and for the convenience of professional management. Additionally, mutual funds are structured with different share classes, each with varying fee structures, allowing investors to choose based on their investment amount and anticipated holding period. The Securities and Exchange Commission (SEC) provides guidance on understanding the fees and expenses associated with mutual funds, which can significantly impact investment returns.7 FINRA also offers tools to compare fund costs.6
Limitations and Criticisms
Despite their widespread use, mutual funds have certain limitations and face criticisms. One common critique revolves around fees and expenses, such as the sales load and annual operating expenses like the expense ratio. Even seemingly small fees can significantly erode long-term returns.5,4 Another point of contention is that actively managed mutual funds often struggle to consistently outperform their benchmark indexes after accounting for fees.3 While professional management offers convenience, it does not guarantee superior performance, and some studies suggest that many actively managed funds underperform passive alternatives over extended periods.2 Additionally, unlike individual stocks or exchange-traded funds, mutual funds are typically priced only once per day, at the close of trading, based on their Net Asset Value (NAV). This means investors cannot trade them throughout the day at real-time market prices. Concerns also arise regarding "closet indexing," where an actively managed fund closely tracks an index but still charges higher active management fees.
Mutual Fund vs. Exchange-Traded Fund
While both are popular investment vehicles that pool investor money to buy a diversified portfolio of securities, mutual funds and exchange-traded funds (ETFs) have key differences.
| Feature | Mutual Fund | Exchange-Traded Fund (ETF) |
|---|---|---|
| Trading | Priced once daily at Net Asset Value (NAV) | Traded like stocks throughout the day on exchanges |
| Pricing | Based on end-of-day NAV calculation | Continuous market pricing (bid/ask spread) |
| Fees | May have sales loads (front, back, level) and ongoing expense ratios | Primarily ongoing expense ratios; brokerage commissions may apply for trades |
| Liquidity | Redeemable directly with the fund | Bought and sold on exchanges, higher intra-day liquidity |
| Tax Efficiency | Generally less tax-efficient for taxable accounts due to frequent capital gain distributions | Often more tax-efficient due to in-kind creation/redemption mechanisms |
The primary point of confusion lies in their structure and how they are traded. Mutual funds are typically bought directly from the fund company or through a brokerage, and transactions occur at the day's closing NAV. ETFs, on the other hand, trade on stock exchanges throughout the day, just like individual stocks, allowing for real-time pricing and intraday trading.
FAQs
How do mutual funds make money for investors?
Mutual funds generate returns for investors primarily through three ways: income from dividends and interest paid by the underlying securities in the portfolio, capital gains from the sale of appreciated securities within the fund, and an increase in the fund's Net Asset Value (NAV) itself. These gains and income are typically distributed to shareholders.
Are mutual funds safe investments?
All investments carry some level of risk, and mutual funds are no exception. While they offer diversification and professional management, which can help mitigate risk compared to investing in single securities, the value of a mutual fund can still decline, and investors can lose money. The level of risk depends on the types of securities the fund invests in (e.g., a stock fund is generally riskier than a bond fund).
What types of fees do mutual funds charge?
Mutual funds charge various fees, which can include a sales load (a commission paid when buying or selling shares), an expense ratio (annual operating expenses as a percentage of assets), and sometimes other fees like redemption fees or exchange fees. It's essential to review a fund's prospectus to understand all associated costs, as fees can significantly impact overall returns.1
Can I lose money in a mutual fund?
Yes, it is possible to lose money when investing in a mutual fund. The value of a mutual fund's shares fluctuates with the performance of its underlying investments. If the stocks, bonds, or other assets held by the fund decrease in value, the fund's Net Asset Value (NAV) will fall, and your investment will be worth less than your initial principal.