How Do Mutual Funds Work?

While maybe not the greatest invention since sliced bread, mutual funds can be one of the best ways for someone to get started as an investor. The mutual fund industry has approximately $20 trillion in assets, with nearly 45 percent of U.S. households owning shares in some form of mutual fund.

What are they and how do they work?

The concept is simple. Rather than buy shares in one specific company, like Apple for instance, an investor can purchase shares in a mutual fund. The fund itself owns a diversified group of investments, and that diversification is passed to the investor when he or she purchases its shares.

As an example, today’s largest mutual fund is Vanguard’s eponymous 500 index, which holds shares in roughly the top 500 U.S. companies by market size. With minimums as low as a few hundred dollars, an investor can buy a fund one of two ways: through a brokerage account (think Schwab, Merrill Lynch, Fidelity, etc.) or directly from the fund company, in the case above, Vanguard.

The history of the mutual fund

While historians are unsure of the exact origin of the mutual fund, many think they got their start in either the 18th or 19th century as a way for smaller investors to access a diversified investment. However, mutual funds really exploded in the 1980s and 1990s, when investments hit record highs both in terms of inflows and returns. More on the history of mutual funds can be found here.

What’s really great?

Instant diversification. You can invest $1,000 into a mutual fund and with that money spread across hundreds, if not thousands, of companies. This simply wouldn’t be possible without the mutual fund structure. Most investors use a combination of funds to build out a portfolio: funds for U.S. and international markets, maybe a fund that focuses on smaller companies and another one for value companies. And don’t forget bonds, which can be challenging to buy individually. One can purchase municipal bonds, corporate bonds, high yield bonds — really the sky’s the limit here.

What do you need to be aware of?

Well, a few things.

  1. Fees and Expenses: All funds have an annual expense that investors pay. This is charged as an annual percentage of your account value and deducted from the value of the fund shares each day. Some funds have fairly low expenses, and some can be really high. Know what you are paying for – click here to find an in-depth discussion on mutual fund fees and expenses.
  2. Trading Fees: You may be charged when buying or selling a fund, which you probably want to know before you trade. This could be a reason someone might purchase mutual fund shares directly from the fund company because they might avoid paying this fee. 
  3. Taxes: Unlike buying a stock, where you control when it is bought and sold, taxes on funds work a little differently. The fund is constantly buying and selling holdings, and at the end of the year, owners of a fund may get a tax bill on income the fund received from interest, dividends or any capital gains that may have be generated from investment sales. Fund taxation is a complicated process that is often subjected to regulatory scrutiny and policy changes, so you should try to stay as up to date as possible. (You can read more on mutual fund taxation here.)
  4. Educate Yourself: There are now over 8,000 mutual funds to choose from, so it can be daunting to find the ones that may be best for you. Be sure to use credible information when educating yourself on what funds may be right for you. A great place to start is the Securities and Exchange Commission’s Office of Investor Education, where you can download Mutual Funds – A Guide for Investors

Mutual funds continue to be a great way for people to invest. Do your homework and consider reaching out to a CFP® professional in your area to find the ones that are right for you and your financial plan.

This article was originally published on CFP® 

Charles Sachs, CFA, CFP®, is a Chief Investment Officer at Kaufman Rossin Wealth, LLC, a Registered Investment Adviser.