How do Mutual Funds Work?

How do Mutual Funds Work

Mutual funds pool the funds from multiple investors to create a larger portfolio. The portfolios may include stocks, bonds, and money market funds. A professional manager oversees the funds and may buy and sell the assets.

Mutual fund investors are shareholders of the mutual fund company. They are not shareholders of the individual companies, though. If the mutual fund company earns profits, you earn dividends. If the company loses money, your shares’ value decreases.

Managing Mutual Funds

As an investor, you don’t have to do anything to manage the mutual fund. The fund manager handles it. It seems scary, but the fund manager makes money on the fund’s performance, so he/she has just as much at stake.

Mutual fund managers can manage these two types of mutual funds:

  • Open-ended funds – The mutual fund manager can add or sell any shares to the fund as needed or desired.
  • Closed-end funds – Only a specific number of mutual shares may be included in the fund. Once the shares are in the fund, they can’t be sold until the fund ends.

How you Earn Money with Mutual Fund Investments

So how do you earn money from mutual funds? As a shareholder, you’ll earn money in one of the following ways:

  • Dividends – The mutual fund company determines when to pay dividends. Dividends are a part of their profit-sharing. They calculate their profits daily. they use the profits to reinvest the funds, pay debt off, or pay the shareholders.
  • Capital gains – If you sell your shares in the mutual fund for more than you bought them for, you earn a profit or capital gain. If you sell the shares for less than you bought them for, you have a loss.

What is Mutual Fund Load?

When you buy a mutual fund, look at the load or sales commission for selling the fund. Mutual fund loads can be as much as 8.5% of the selling price. Your mutual fund load may be one of the following:

  • Front-load – You pay the commission for the mutual fund when you buy it
  • Back-end load – You pay the commission when you sell the mutual fund
  • No-load funds – There isn’t a sales fee or salesperson involved in the mutual fund

Types of Mutual Funds

You have three options when purchasing mutual funds:

  • Equity funds – This fund invests only in stocks. It has the largest risk, but also the greatest reward.
  • Fixed-income funds – This fund invests in ‘safe investments’, such as corporate and government bonds. The risk is lower, but so are the returns.
  • Balanced funds – This fund balances between equity funds and fixed-income funds. It diversifies the risk and provides a return that’s in between equity funds and fixed-income funds.

How are Mutual Funds Managed?

Mutual fund managers can manage mutual funds in two ways – passive or active. Passive funds track a specific index. They aim to match the index’s performance. There’s little management or investment skill needed. Passive funds typically have lower fees.

Active funds try to outperform the indices. They have more aggressive investments and more frequent trades. Active funds may have higher earnings in the short-term, but over the long-term, passive investments often perform better.

How to Buy Mutual Funds

You can buy mutual funds in one of two ways:

  • 401K – Most 401K programs include at least a few mutual funds. If your account doesn’t, but you want them to, you can speak with your sponsor about adding them to your 401K portfolio.
  • Brokerage account – You can also open your own brokerage account to buy mutual funds. Many online brokerage accounts have no deposit requirements and low commissions.

The Benefits of Mutual Funds

Why should you consider mutual funds among the many investment options you have? Here are a few benefits:

  • Hands-off investing – Once you choose a mutual fund, you don’t have to anything else, the mutual fund manager handles it
  • Affordable – Mutual fund managers often set low minimum requirements. This increases the funds’ popularity. Managers often waive funds with a minimum required investment if you set up automatic deposits.
  • Automatic diversification – You don’t have to worry about diversifying your portfolio because mutual funds are automatically diversified
  • Liquidity – You can sell mutual funds in a taxable account. But if you have mutual funds in a 401K or IRA, you may pay taxes or penalties for the early withdrawal.

Mutual funds can be a great addition to your portfolio. Do your research, know the funds’ fees, and whether it’s actively or passively managed before buying.

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