What Are Mutual Funds and How Do They Work?

The definition of a mutual fund

A mutual fund is a different type of a company where the money comes from various investors. In addition to that, they try to invest in securities that do not represent an incredible risk to the participants.

The most important part of a mutual fund is its portfolio. In contrast to regular investing, the portfolio consists of all kinds of investments. Hence, the mutual fund does not have to buy shares in one sector only. Moreover, it is better if they invest in a variety of mixed stocks and money market instruments. That way, there is less risk for all of the members and a higher chance of capital gains or income.Mutual funds

Who are the members?

Mutual funds are the best option for investors who do not have a lot of money or those who are new on the stock market. Furthermore, it is also a fantastic ground for participants who have never invested before and are scared for their income.

However, all shareholders join individually and they split the gains or losses proportionally.

How is it different from other companies?

A mutual fund is a way to become an investor and a company owner at the same time. Once you invest your money in it, you own shares of the fund. However, at the same time, you also have an income based on the assets. Moreover, your profit depends entirely on the performance of the portfolio – not individual stocks you own.

That is the essential difference between owning stocks on your own, and investing in a mutual fund. There is a higher chance of diversification. In addition to that, the risks are lower than usual. You would suffer significant losses in other situations. For example, if you owned stocks from a company that had a bad quarter. However, if they are just a fraction of the portfolio of your mutual fund, your losses would be lower.

How do mutual funds work?

Just like with any other company, it should have a financial advisor. While mutual funds are a virtual business, they have a board of directors that hire a manager. This person can be a shareholder himself, although it is not obligatory.

His job is to do everything he can to preserve the income and the portfolio of the mutual fund.

Apart from him, there are few employees in a mutual fund. Usually, there are also market analysts, an accountant, one or two compliance officers, and an attorney.

Types of mutual funds

  • Fixed income funds – their main aim is to invest in government or corporate bonds, or debt investments.
  • Index funds – they buy only the stocks that have a significant market index.
  • Money market funds
  • Balance funds
  • Sector funds
  • Equity funds
  • Funds-of-funds – some mutual funds actually buy the shares of other similar companies.Mutual Funds Type


There are two types of fees in a mutual fund. Those that cover the operating costs during the year, and shareholder fees.

Clean shares funds

There is a newer type of a mutual fund on the market that uses  “clean shares.” That way, there is a supreme level of transparency among the shareholders. Furthermore, there is a higher chance of bigger savings.

Pros and cons of mutual funds


  • Diversification – mutual funds smartly invest in all sorts of stocks and bonds.
  • Economies of scale – the transaction fees are lower.
  • The funds are accessible, and they provide individual investors to participate in the market of exotic commodities or foreign equities.
  • Professional guidance – financial advisors are there to help you gain an income.
  • Perfect for individuals who do not want to participate directly in the market.


  • Diworsification – they might make a mistake and buy funds that are closely related.
  • Expense ratio costs are high
  • Sometimes, there is no transparency. And the purpose of the fund might not be clear to everyone involved.
  • Some of the portfolios are cash-based.
  • There is no guaranteed return, and FDIC does not insure money market funds.
  • The shareholders cannot compare earnings per share and other variables, making it hard for them to determine which fund is the best one.

Evaluating the Performance of Your Mutual Funds

When choosing which mutual fund to invest your money in, you may go off the one-year return rates, and arrive at the conclusion that a particular fund was very successful. However, it is not enough to merely look at the return rates for one year. Instead, you should take a look at a couple of years back, and even perhaps the whole history of the fund.

For example, if a particular fund boasted stellar returns last year, but we look at the average returns over the last 3 or 5 years, and they turn out to be much lower than the one year return rate, it is possible that the fund actually lost money in one or more of the years in question, even though the average return percentage remained positive.

mutual fund analysis

Relative Performance

The way in which we judge the performance of a mutual fund is fundamentally relative, and there is no empirically correct way to do it. The best way to gauge a mutual fund’s performance is, therefore, not to rely on the return percentages, but to compare its performance with other relevant data, in particular, with the performance of the appropriate stock index and with other similar funds.

mutual fund performance

Firstly, in order to see whether the mutual fund performed well, we need to ask the question of whether it accomplished its mandate. The reason people invest in mutual funds is that they expect it to be able to secure better returns than an index fund, which passively tracks the stock market. This is called ‘beating the market’, and it is very tricky to do consistently.

Market Benchmark

In fact, according to the efficient market hypothesis, it is impossible to consistently beat the market, since all the information about the future price of any financial instrument, be it stocks, bonds, or derivatives, is already contained within the price of the instrument itself. There is a wealth of evidence to support this claim, but it has still not been accepted as an unquestionable rule.

Going off the efficient market hypothesis, it is a good idea to compare the performance of a mutual fund with the relevant stock index. Large equity funds are most often compared with the S&P 500, whereas small equity funds are compared to the Russell 2000. Comparing the performance of a mutual fund with the wrong index can yield incorrect results, so it is important to know which index to compare it to.

s&p performance

This benchmark is even more effective when another layer of scrutiny is added. When considering the performance of a mutual fund, it is also important to take a look at how other funds in a similar family performed in comparison to the index. If we find that the fund we are evaluating stuck with the herd in terms of the investments it made, and the returns are similar, this should be seen as an average performance.

If, however, the fund we are evaluating chose to invest in different stocks, there can only be two results. Either it fared better than its peers by virtue of being able to select better stocks, or it fared worse, because its investment strategy didn’t pay off. Naturally, the goal of any investor is to invest in a fund that can maximize the returns by selecting stocks well, thereby beating the market.

However, even when comparing the mutual fund in question with its peers, there are data points which can be misleading. Fund companies paint a rosier picture of their overall performance by shuttering those funds which have lost money. That way, the composite performance of the fund company is improved, because the losers are removed from the statistics.

Full Performance Analysis

Thus, a general conclusion can be reached when the method of evaluating the performance of mutual funds is concerned. The trick to evaluating performance accurately is not to look at discrete data points in isolation, but rather to correlate as many points of data as you can, in order to have a clear picture.

Even though technically the management of your mutual fund works for you, their goals and your goals are not always aligned, since they get paid whether or not they were able to deliver results. Furthermore, their aim is to keep you invested in the fund for as long as possible, so they have developed ways of papering over their mistakes in order to make it look as though things are fine, even when they’ve made mistakes. Therefore, you would do well to constantly question the performance of your fund, and not to take management at their word.

Everything you Need to Know about Mutual Funds

Put simply, mutual funds are a collection of bonds, stocks, and other securities that are owned by several investors, and they are managed by an investment company. When money is invested in a mutual fund, it is put together with more money from like-minded investors. Having such a big amount of money gives you much more purchasing power than you’ll ever have if you try to invest on your own. It is not a complicated concept. It’s like groups of friends or coworkers who buy lottery tickets together. When the money is pooled, they can afford many more tickets, thus giving them a better chance at winning. Mutual funds can be purchased directly from the fund companies, or through what is known as a “supermarket” which will have funds available from many providers.

Choosing a Mutual Fund

Choosing a Mutual Fund

Although it is a fairly simple thing to do, there are endless amounts of mutual funds to choose from, and you’ll want to do some research before picking what you want to invest in. The first thing to consider is the fact that some mutual funds will charge something called a sales load. It’s a fee that is usually about 5% of the assets, and it is paid to whoever is selling you the fund. This can be beneficial to you if you are a wealth manager, but for someone who is trying to create a portfolio, you will want to stick to mutual funds with no sales load. This is simply because when you invest in a no-load fund, all your money goes to work for you right away.

Mutual Funds

Turnover Ratio

You will also want to avoid mutual funds with a high turnover ratio. A lot of people will go right to thinking that they need to just get the highest return for their money possible, but, the goal should be to have the most possible money after taxes in the end. For this reason, it is sometimes hard for some people to believe that you will actually get more out of a fund that can generate 12% growth but with no turnover, than a fund that has 17% growth, with 100% turnover. The reason is simple – taxes.

Turnover Ratio

Other Fees

In addition to a possible sales load, there can be other fees associated with mutual funds as well. There are fees that are known as back loads, which are charged once you sell a fund. They can also be known as deferred sales charges, and they are usually around 5%. They can decline or even go down to zero over time, typically after about five years, sometimes more. There also expense ratio’s to be aware of, which are charged in exchange for the fund being managed professionally.

Investing in mutual funds can be extremely lucrative, but it takes some time to learn how to pick the right companies and the rights funds. It is also a good idea to do some research before making any choices, as there are a lot of options out there and not all of them are equal!

The Fees and Costs Associated with Mutual Funds

It is important that a would-be investor be aware of all of the costs that come with investing in a mutual fund before deciding whether they are the right option for their needs. These costs are not always laid out as clearly as is the case with regular stocks or bonds.

With stocks, you are expected to simply pay a broker the fee you’ve agreed upon, and that’s it, whereas with buying stock in mutual funds, you may also have to pay a fee, but there may also be other costs, some hidden with obscure language that may be difficult for an average investor to follow. However, every mutual fund prospectus must spell out the fee schedule in a table that is to be updated yearly.

Fee Categories

There are two main categories in which mutual fund fees may be subdivided. Firstly, there are ongoing annual fees, which keep you invested in the fund. These are expressed in terms of the expense ratio, also referred to as the management expense ratio (MER). These expenses are usually taken out of the return you get from your investment, instead of being billed to you directly. This fee which reduces your return can further be subdivided into two basic fees.

Management Fees

Firstly, there are hiring costs, more commonly known as management fees, which usually range from 0.5% to 2% of the assets. This is the main reason why mutual fund managers are exceedingly wealthy, since even 1% of such vast sums of money amounts to very significant numbers indeed. MInd you, these fees are paid out to the fund manager regardless of the fund’s performance, so it is questionable how a fund manager earns their fee if they have not secured significant returns for their investors.

management fees

In fact, it has been shown repeatedly that managed funds such as mutual funds are unable to consistently beat the market in terms of the return they can generate for their investors. This is especially true when we take into account the reduction of returns because of all of the fees the management extracts.

Distribution and Service Fees

The other part of the expense ratio consists of what are usually called distribution and service fees, which go toward paying brokerage commissions and advertising the mutual fund. When the fund management buys or sells some fund assets, the fees that are incurred get passed down to investors. Furthermore, by buying stock in a mutual fund, you are also paying for it to market itself to other investors. This advertising takes the form of prospectuses, billboards, commercials, and other means of promotion.

These fees are regulated by law, and cannot exceed 0.75% of any given fund’s net average assets per year. Furthermore, service fees which are used for advertising purposes cannot exceed 0.25% of average net assets per year. In the US, these fees are known as 12b-1, and if you want to learn more about them, you would do well to look the code up.

Loads and Shareholder Fees

The other broad family of fees are so-called loads and shareholder fees. Loads are the fees the fund uses to pay the broker who sold you shares in the mutual fund. Shareholder fees are the other costs that come with the transaction through which you buy or sell shares in a mutual fund, and these are billed directly to the shareholder.

shareholder fees

Sales loads can further be subdivided into front-end loads and back-end loads. Front-end loads are the fees that you are expected to pay at the moment of buying mutual fund stock. These are usually taken out of your total investment in the fund, and are usually calculated as a percentage of the investment.

Back-end loads are paid when you want to sell your shares in a mutual fund, and these are a bit more tricky. These are designed to incentivize you to keep owning the shares for a long period of time, since they are only charged if you sell your stock within a certain time of buying them. If you sell the stock after the specified time, these costs are reduced to 0%.

Mutual funds usually charge a combination of front-end and back-end loads, as well as all the other fees we’ve discussed previously. These are often an untraversable maze for the average investor, and they are often not worth the return you get in the end. That is why it is especially important that you choose the mutual fund you end up investing in well. These fees can be calculated by handy online tools, to help you keep abreast of what you should expect to pay. A good example of this is Finra’s Fund Analyzer.  

Choosing a Mutual Fund

As discussed previously, it is very important that you choose the right mutual fund, for several reasons. Firstly, you need to take into account its business model, as well as the fees and costs involved with holding stock in such a fund. Secondly, and probably more importantly, you need to define what your financial goals are, i.e., why you are investing in the first place.

You may want to put all your profits into your current account, in order to spend it on everyday expenses. This would be considered a s short-term investment. However, many people use mutual funds as a means of securing their long-term financial future, such as planning for retirement, or making a college fund for their child.

Depending on the reason for investing there are several different types of fund to choose from. If you needed cash for short-term spending, you would do well to invest in a money market fund. For spending in a few years’ time, bond funds are the best choice, and finally, for long-term investments, stocks funds are the best bet.

Types of Mutual Funds

Another important consideration when considering the type of fund you want to invest in is your risk tolerance. If you think you would be able to afford and cope with dramatic swings in portfolio value, for example, you may want to invest in stock funds instead of bond funds. If you are more conservative in your risk tolerance, the better choice would be investing in a bond fund. The most conservative choice is the money mutual fund, which is also considered to be something of an alternative to simply holding cash.

types of mutual funds

The other main aspect to choosing a mutual fund is actually finding one that suits you. Finding mutual funds has been simplified considerably by the advent of the internet. A simple Google search using the search term ‘mutual fund’ will yield millions of hits, and the most reputable funds will likely emerge among the top results.

There are also other online services and resources which may be able to help you with your choice. You can use sites such as Morningstar and Kiplinger to research mutual funds, since they carry a lot of information that is up-to-date and reliable. Also available is the Mutual Fund Education Alliance (MFEA), which is a non-profit trade association which provides search tools that allow you to find no-load funds.

Niche sites can also be useful, if you can find one that aligns well with your needs and investing philosophy. LipperLeaders, for example, is a company owned by Thomson Reuters, which evaluates funds on the basis of five metrics considered most important to the functioning of mutual funds. They call these metrics ‘Leaders’. They include the total historical return, consistency of returns, preservation of capital, expenses, and tax efficiency.

Buying Mutual Funds

Once you have found a fund that aligns with your interests, the next question is how the procedure for actually buying into it works? There are many ways you can come into possession of mutual fund stock. You could buy stock through a broker, a bank, an insurance agent, or a financial planner. These usually extract a fee in order to to this on your behalf, but if you want to avoid these, there are funds which also sell stock directly, and charge no fees to do it (other than the stock price, naturally).

There are also low-fee programs which offer stock in many different mutual funds in one place. These are often referred to as ‘fund supermarkets’, and they even offer record keeping services that keep track of all the purchases you made through them, even if you buy into different fund families. Some examples of ‘fund supermarkets’ include Schwab’s OneSource, Vanguard’s FundAccess, and many others.

vanguard funds

Once you have found a mutual fund you are interested in investing in, you should keep note of the share price. The share price for a mutual fund is calculated based on its net asset value (NAV), which is the fund’s assets minus its liabilities. NAV per share is the value of one share in the mutual fund, and this is the first number available to the potential investor when researching mutual funds. As any share price, the NAV per share fluctuates in value daily, as the holdings and liabilities of the company change.

What are Mutual Funds?

The basic definition of mutual funds is that they are managed portfolios of stocks and/or bonds. Another way we could approach defining a mutual fund may be to say that mutual funds are companies with lots of clients or shareholders whose money is accumulated and invested into shares and/or stocks with the aim of making a profit for the shareholders. The fact that the fund is owned by a lot of small shareholders is the reason they are called ‘mutual’ funds.

Mutual Funds vs. Individual Stocks

There is a fundamental difference between investing your money into a company’s stock, or buying bonds, and investing in a mutual fund. Firstly, buying stock in a mutual fund does not give you any voting rights, which you could use to influence the fund’s business decisions. Furthermore, stock in a mutual fund practically represents partial ownership of a wide array of different companies and their stocks.

Mutual Funds

The way in which an investor can profit from a mutual fund is also a bit different from owning regular stock. There are three main ways in which an investor can make money off a mutual fund. Firstly, the fund may invest in various companies on the shareholders’ behalf, and once profits are extracted from these investments, they get distributed to the shareholders according to their ownership of the fund’s stock.

The shareholders are usually allowed to decide whether they want to re-invest these profits by buying more of the fund’s stock, and thus gaining more of the profits in the future, or whether they merely want to pocket the money and keep their ownership percentage the same.

Secondly, the fund may also sell off some of its securities, if these have increased in price to an extent considered profitable by the fund managers, thus accruing a capital gain. Most of these gains are also distributed to shareholders in the same way as the above case.

Finally, if the holdings of the fund increase in value, the fund’s stock price will also increase. This is an opportunity for an investor to sell off some or all of their stock in the fund in order to make a profit. This works exactly the same as it would with any other company.

Naturally, as with any sort of investment, investing in a mutual fund has its benefits and drawbacks. Let us take a look at some of them so that a clearer picture of the essence of mutual funds can be formed. Let us examine at some of the advantages of mutual funds.

How Mutual Funds Work

Advantages of Mutual Funds

Firstly, the main advantage of mutual funds is arguably the fact that they are managed by professionals. This is important due to the fact that people with proper training and experience know how to pick which stocks and/or bonds to include in a portfolio in order to maximize the profits in a way that is safe for the investors. On top of that, a mutual fund may have more information on which to base these decisions, as opposed to a single small investor.

Another advantage of mutual funds is the fact that diversification is baked into the business model. Diversification is a very important aspect of any portfolio, since it allows you to minimize the risks associated with any particular investment, since you own a small amount of stock in many different firms, so if one of those firms goes bust, you end up losing relatively little money.

The fact that any given mutual fund has so many shareholders and owns such an array of stocks allows for the exploitation of economies of scale. Firstly, since mutual funds buy and sell large amounts of securities quite often, that means that the transaction costs are lower than those an individual would likely be required to pay to accomplish the same thing. Furthermore, when the money of many small shareholders is pooled together, it can allow the management to make much more aggressive and profitable investments than an individual would be able to.

Disadvantages of Mutual Funds

However, there are also disadvantages to holding stock in a mutual fund. Firstly, managed funds have not proven particularly effective in achieving higher rates of return for their investors than passive index funds, which track the stock market, in the last few years. Furthermore, the fees and costs of owning stock in a mutual fund are also considerable, and they can eat into an investor’s profits.

mutual fund fees

When we combine these two disadvantages, we arrive at the question of why we should invest in a fund which may not even beat the market, while managers get paid whether they win or lose? The answer to this question comes down to choosing the right fund to invest your money in.

Is Fidelity Still the Leader in Mutual Funds?

From the look of things, Fidelity is still the leader in mutual funds. If you are looking for a great investment company then Fidelity is it. They are really good at buying shares back and using it to invest in diversified sercurities of other companies. I mean you get a really return on your money.

We all know about the economy is bad at this time and handling your money, your investments shall I say, your retirement, 401′s all of this is really important. One has to make wise decisions and study the economy before making rash decisions. But if it’s your time to investment I say start with Fidelity, look at the “fixed” options due to the economy and then make your move. If you are already invested – just hold still and don’t make any sudden changes – see how this whole economy thing turns out first with the debt ceiling and so forth.

As one knows investment returns and principal values will fluctuate but for the most part Fidelity has it going on. To give you an example of the price history–on average for 12 months, the price ranged from 41 – 57 and on average monthly prices could have or will range from 54 – 57. So study carefully and make wise decisions.

The Best Performing Mutual Fund Companies

One of the more popular savings vehicles are mutual funds. If you do not feel comfortable researching and buying mutual funds on your own, it may be helpful to seek the assistance of a mutual fund company. When looking for a company it is important to consider what type of investment you are interested in. Are you interested in capital or financial investments? It is also important to look at past performance of the mutual fund companies you are considering.

Another thing to consider is the fees that will be charged by the company. Also look at the kinds of companies and range of services they cover. Sometimes it is recommended to try to invest in companies and products that you normally use. Check to see if the company offers diversified choices so that all of your investments are not in one sector. When you have your investments spread over different categories, if one type drops in value, your portfolio may be in better shape if others you have remain stable or rise in value.

As with other financial matters, it is important to do research on the companies you are considering and feel comfortable with the people you are dealing with.

Should You Stick With One Mutual Fund Family?

Mutual funds, as with any other investment opportunities which consumers choose to purchase, must be diversified in order for you to get the largest return on investments, and to be able to really make profits on your investment accounts. So, when you are considering where to purchase mutual funds, and whether or not to stick with only one company, the answer is definately not. You have to take risks, especially with products like mutual funds which are low in risk, therefore, your risk of loss is very small. So, when purchasing mutual funds, look into the top comapnies and diversify your portfolio with 2 or 3 of the best mutual funds out there.

To really make profits, you must be willing to take a few chances. You should not be foolish, you have to invest with companies that are the top dogs in the market, but you do have to diversify your accounts, and make sure that you spread your money evenly. Therefore, if one of the mutual funds purchases made doesn’t perform so well, you still have a couple others out on the table, which are still capable of briniging in returns for you, and maximizing your profits made.

How to Select the Right Mutual Fund For You

Everyone wants to find the right mutual fund that fits them. You should first consider seeking advice from a professional who knows what they are talking about. You can speak to an investment coordinator or even a financial advisor. You can also evaluate the fund’s past performance. This will give you may ideas of the fund that is right for you. You can narrow your search, and choose from the remaining. You can also explore the market and come up with many solutions. You can see which domestic or foreign funds are performing best. You can then make your choice from there. It all depends where you would like to get your information from. If you know how much of a risk that you are likely to take, you can make a decision from that. You should consider how quickly you would like to make money when determining the risks involved. It may be best to select a lower risk fund if you are someone who is new to this. You will have a longer time to let your investments grow way before you need to get into them. You have to weigh out your options when selecting the best.