What Are Mutual Funds and How Do They Work: All The Basics
Want to know how mutual funds work? Mutual funds are baskets filled with different types of investments (usually stocks) that allow people to invest while mitigating the risk of choosing individual securities.
Instead of requiring investors to pick individual stocks themselves, mutual funds allow investors to simply choose types of funds that would suit them.
And theyre typically one of those personal finance topics people pretend they know about but dont actually have any idea what they are.
Here’s what we’ll cover in this article:
How Mutual Funds Work
Mutual funds work by pooling your money with the money of other investors and investing it in a portfolio of other assets (e.g. stocks, bonds). This means youll be able to invest in portfolios that you wouldnt be able to afford alone because youre investing alongside other investors.
For example, there are large-cap, mid-cap, and small-cap mutual funds, but also mutual funds that focus on biotechnology, communication, and even Europe or Asia.
Mutual funds are extremely popular because they allow you to pick one fund, which contains different stocks, and not worry about putting too many eggs in one basket (as you likely would if you bought individual stocks), monitoring prospectuses, or keeping up with industry news.
The funds provide instant diversification because they hold many different stocks. Most peoples first encounter with mutual funds is through their 401k, where they choose from an array of options.
Mutual funds are typically managed by a fund manager, who picks all the investments in the portfolio. This is often a big selling point for beginner investors who dont have much experience and would rather place their faith in an expert in the mutual fund world.
(Anyone who tells you theyre an expert and can out-play the market is lying because they cant actually predict what will happen.)
Because these fund managers actively manage your money, youll sometimes hear mutual funds referred to as actively managed funds. Theyll also charge a variety of fees for their work (which Ill go into more later).
And if you want to invest in a mutual fund, the mutual fund manager is important. Youre essentially investing in them by putting your money in their fund. They have A LOT of incentive to do a good job for you, as their jobs literally depend on how well the funds perform. They also receive bonuses in the millions if they do a good job.
How Mutual Funds Pay
Mutual funds pay out two different ways:
- Distributions. If a mutual fund contains an asset that pays dividends (i.e., money a company pays out to shareholders), the fund manager must distribute the dividends to the fund owners. The distributions can also come in the form of interest and capital gains which brings us to …
- Capital gains. You accrue capital gains money when you sell your mutual fund for more than you initially paid for it.
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The dollar amount you earn from each depends on a variety of factors. One of the most important factors is your mutual fund manager.
Like I mentioned before, the manager has a vested interest in doing well and choosing great assets for the mutual fund but does that mean that the majority of mutual fund managers are able to beat the market?
NOPE.
According to Dow Jones, 66% of large-cap (big company) mutual fund managers failed to beat the S&P 500 in 2016 (the numbers are even worse for mid- and small-cap managers).
And when that same study looked at actively managed mutual fund performance over 15 years (you know, close to the length of time youd keep your money in to save for retirement), more than 90% fail to beat the market.
So lets recap:
Advantages of how mutual funds work:
- Mutual funds are very hands-off when it comes to investing. This means you dont have to worry about actively managing your funds on a day-to-day basis.
- These funds hold many stocks, so if one company tanks in your fund, it all doesnt go down as well.
- Mutual funds are an easy way to make a diversified investment.
Disadvantages of how mutual funds work:
- Many funds charge an expense ratio as well as possible upfront fees in order to be run by an expert (the next section explains this more).
- If you invest in two mutual funds that overlap investments, youll get a less diversified portfolio (e.g., if you have two funds that both hold Microsoft, and Microsoft implodes, then you get hit twice). You can fix this by getting an index fund that invests in the entire market though.
- Youre paying an expert to manage your hard-earned money and they rarely ever beat the market.
If youre not careful, you might end up investing in a mutual fund that:
- Charges you a bunch of fees.
- Is managed by someone who could lose you your money.
Boy, I wish there was a way to get all the pros and barely any of the cons. *STROKES BEARD*
The Types of Mutual Funds
Mutual funds are like the different scents at a Yankee Candle store there are an INSANE amount of different kinds. Each with their own benefits and drawbacks.
You can pick a mutual fund based on a variety of different factors including risk, return, sector, geographic area of investment, and more. For example, you can invest in a fund focused on different energy services, or a fund focused on emerging-markets, or even a fund for medical devices.
These funds tend to fall into even bigger buckets. Each one comes with their own benefits, drawbacks, and stipulations before you can invest in them. Lets take a look at four of them now:
- Money market funds. These are high-quality, short-term (less than one year) investments in securities issued by the government (who issue US Treasury securities like CDs), or corporations (who issue commercial papers). They have the lowest returns because they have the lowest risk.
- Bond funds. Otherwise known as fixed income funds. As the name implies, these funds invest and trade different kinds of bonds (investments in the form of debt a company owes to an investor with a fixed interest rate). They typically have higher returns than money market funds but come with more risks, since all bond funds are affected by interest rate risks (if rates go up, bond fund value drops).
- Equity funds. Also known as stock funds because they invest in well, stocks of many different companies. They come in three different ways: Large-cap (big blue-chip companies like Apple or Google), mid-cap (companies that arent behemoths but arent start-ups either), and small-cap (smaller companies).
- Hybrid funds. These are a mix of stocks, bonds, and other investments. Many of these funds can even invest in other mutual funds. Thats right. Its mutual funds in mutual funds.
And theres actually a fifth type of fund I havent gone over yet and its the best one.
Can you guess what it is?
Why Index Funds Rock
Index funds are my favorite type of mutual funds. Period.
Most mutual funds charge a fee called an expense ratio (or management expense ratio). This is an annual fee thats typically around .25% to 2%. Its paid out through the returns of your fund.
This money goes towards a variety of areas that are mostly BS, including the fund manager, administrative costs, and a distribution fee thats used to advertise your fund.
Also, when you purchase a mutual fund, you may be asked for a commission called a sales load that comes in two forms:
- Front-end load. Paying a fee when you purchase a fund.
- Back-end load. Paying a fee when you sell the fund.
AVOID BOTH OF THESE.
Instead, you want a no-load fund. Why? Loads cut into your profits and theres zero evidence they produce any results. In fact, no-load funds tend to outperform load funds. Seriously, its just silly that anyone goes with them.
So what kind of mutual fund offers no sales loads, low expense ratios, and doesnt require an active money manager?
(Psst, index funds!)
Index funds are a special type of mutual fund that, instead of being actively managed by an expert, is tracked using software that matches the stocks in the market. And remember how almost no actively managed mutual funds beat the market? Well, an index fund is essentially betting on the market.
For example, Charles Schwab has their Schwab S&P 500 Index Fund that has every stock in the actual S&P 500.
How much do you think the expense ratio is?
.03%
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Thats it! No front- or back-loading fees, and no money manager who might screw up your investments. Just the opportunity for you to invest directly into the market.
Many brokers such as Schwab also have index funds that invest in an international market as well as the 1,000 largest publicly traded companies in the United States.
Since index funds invest in the entire market, theyll be less volatile which means youll earn money slower. But if you keep your money in the market over your lifetime, I promise you youll make money.
I LOVE index funds and Im in good company:
[Most investors would] be better off in an index fund. -Peter Lynch
Just buy the damn index funds. -John Bogle
Consistently buy an S&P low-cost index fund. Its the thing that makes the most sense practically all of the time.”
There’s a reason index funds are a favorite of financial leaders and thinkers out there. Its because they WORK.
So lets recap. Again.
Advantages of index funds:
- With less risk, you stand to make a lot more money with index funds.
- You save money on dumb costs because index funds dont have money managers or sales-loading costs. Your expense ratio is also much lower.
Disadvantages of index funds:
- Slower gains in funds.
- Thats it.
Okay, Im sold. How do I invest in a mutual fund?
When it comes to actually purchasing a mutual fund and investing, I suggest two places.
Roth IRA and 401k
Your retirement accounts (Roth IRA and 401k) let you purchase index funds. To do so through your 401k, youll have to speak to your companys HR department to set up an investment plan through the mutual fund you want. And, as Ive written, the S&P 500 index fund is a great place to start.
If you want to invest through your Roth IRA, youll have to set it up through a brokerage.
Check out my video below, where I suggest a few good ones to help you get started with your Roth IRA.
Banks, credit unions, and stockbrokers (oh, my!)
Banks, credit unions, and stockbrokers offer avenues to invest in mutual funds. In fact, there are plenty of fantastic brokers that offer a wide variety of mutual funds for you to choose from.
My suggestions:
- Vanguard (This is the one I use)
Phone #: 877-662-7447 - TIAA
Phone #: 800-842-2252 - Charles Schwab
Phone #: 800-435-4000
All of these places offer an excellent variety of index funds to choose from, so you cant go wrong with them.
Signing up is ludicrously easy. Just follow the 7-step guide Ive outlined below (the wording and order of the steps will vary from broker to broker but the steps are essentially the same).
NOTE: Make sure you have your social security number, employer address, and bank info (account number and routing number) available when you sign up, as theyll come in handy during the application process.
- Step 1: Go to the website for the brokerage of your choice.
- Step 2: Click on the Open an account button. Each of the above websites has one.
- Step 3: Start an application for an Individual brokerage account.
- Step 4: Enter information about yourself name, address, birth date, employer info, social security.
- Step 5: Set up an initial deposit by entering in your bank information. Some brokers require you to make a minimum deposit, so use a separate bank account to deposit money into the brokerage account.
- Step 6: Wait. The initial transfer will take anywhere from 3 to 7 days to complete. After that, youll get a notification via email or phone call telling you youre ready to invest.
- Step 7: Log into your brokerage account and start investing!
The application process can be as quick as 15 minutes. In the same time it would take to watch half an episode of Rick and Morty, you can be well on your way to financial success.
If you have any questions about funds or trading, call up the numbers provided above. Theyll connect you with a fiduciary who works for the bank to give you the best advice and guidance they can.
Beyond Mutual Funds
If you want even more actionable tactics to help you manage AND make more money, youre in luck. I wrote a FREE guide that goes into detail on how you can get started doing just that.
Join the hundreds of thousands of people who have read it and benefitted from it already by entering your information below to receive a PDF copy of the guide.
When youre done, read it, apply the lessons, and shoot me an email with your successes I read every email.
FAQs About Mutual Funds
What is the best mutual fund?
A mutual fund’s viability depends on the investor’s goals, risk tolerance, and investment objectives. To help you find appropriate funds, we have researched leading options and identified the best mutual funds.
How are mutual funds are taxed?
Whether you hold your mutual fund shares as cash or reinvest them in additional shares, you must pay taxes on distributions, including on capital gains and dividends. In a registered plan such as an RRSP, an RRIF or an RESP, you don’t pay tax on your investment income as long as the money stays in the plan. When money is withdrawn from a registered plan, it will be taxed as income.
If you aren’t sure how to handle your taxes, consult a tax professional.
Are mutual funds safe?
Mutual funds are considered a lower-risk investment than individual stocks. Their diversification allows the average investor to participate in a greater number of company stocks without taking on unnecessary risk.
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34 Comments
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Anonymous
Hi Ramit Mistake in the previous comment - the expense ratio is 0.79%, not 0.79. My bad there. Also, The SP 500 is 0.18%. Pls also ignore the comment on the management fee at fidelity. But given the low expense ratio and the extent of the diversification, it looks very attractive, and SIMPLE. thanks c
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Brandon
Thanks for this article. It inspired me to actually take a look at the performance and prospectus information of the available investment options in my company's 401k. Lo-and-behold, found an S&P 500 index fund. After checking out the cost ratio of the mutual funds in the program and then realizing that by using the goal-directed investment model provided, I was probably spending even more than the 1.6-2% cost ratio of the individual funds, decided it was time to take more control of my investment direction and stop being lazy. One of these days I'll figure out how to get more control of the money in that 401k, but until then at least I can waste less of it on fund managers.
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wwsuccess
Ramit, I don't disagree that index funds are better than 85% of mutual funds. But since the performance of mutual funds is so easy to find, why not invest in the 15% that actually beat the market at a reasonable cost? I have been investing in Selected American Shares for many years and they've been beating the market in every time horizon, without charging exorbitant fees.
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Ramit Sethi
Because you don't know which ones will beat the market until you look backwards in time.
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Corey Jewett
Just in case Ramit's case wasn't already convincing enough: http://www.sanfran.com/home/view_story/1507/
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Gabriel
I disagree with you, Funds are a great investment if have a moderate ammount of knowledge. I didn't see you talk about the risk of the funds (debt vs. stocks), if you study the funds you want to invest in and you know the risk you can tolerate, you can make a pretty good investment. For example I invested in a couple of funds three months ago and I have managed to get a 16% return, already having paid all the operational costs. I think it's a great way of saving money, if you¡re willing to leave your money in there for 3 to 5 years and spend some time studying the funds you are going to invest in
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Lindsey
Hi Gabriel, Do you assist people with investing? I would like to ask you some questions via email if you would be willing. Thanks, Lindsey
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blogginginvestor
Good article. I will now actually look at the performance of index funds in India after reading your article. I was under impression that actively managed mutual funds are the best bet.
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Brian
While index funds are superior to actively managed funds, there is a strange paradox in that the more popular index funds become, the less likely they are to outperform actively managed funds. Index funds work on the premise that the value of all stocks is accurately reflected in their market prices - that there is no advantage to searching for mispriced stocks, something that goes on all the time with actively managed funds. As more money flows into index funds and out of active funds, the chance of finding mispriced stocks in the market increases. Eventually, the more mispricings a fund manager can capitalize on, the more likely he/she is to earn a return in excess of the market return. Bottom line is, index funds work best only when there is more money in actively managed funds.
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Reality Bytes
I am being actively sold on hedge funds. I imagine that index funds will do poorly if the market takes a downturn. So too will Mutuals? I wonder what Ramit's opinion is?
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marvin
the problem with index fund is you can't really mimic the index fund. Since all the index fund will try to buy in and buy out at the same time and that's probably several % right there lost to other mutual fund. Or they have to wait which means they are not true index fund. What's you take on this? Some financial planners suggested just opposite of what you said here.
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rob
Strangely the vast majority of people are financial illiterate, (basically a pet peeve, the reason our primary education system is so poor is that the worst enemy of a politician is an educated voter, few politicians desire an educated consumer) and trust without verification, and sadly do not want to spend even sixteen hours per year investigating the numbers and what they actually mean, and compare them to the alternatives. They just turn it over to there broker, and let him decide. That is the sole reason the bottom 85% of the mutual funds exist coupled with fads that one can talk about in social settings. Just like all investments, including Mutual Funds (MFs)– Each investment has to be audited periodically. I been quite successful with MFs, my main screen points are: 1) No loads, I always been able to find a equal to or better mutual fund with without a load (excluding 12b-1 fees, which I do try to minimize). This I believe has been widely documented one rarely gets anything for paying a load. 2) Small Mutual funds on total assets, basically it is easier to turn a row boat than a aircraft carrier, and typically the manager more hungry. 3) Low turn over rate. Basically if there is typical above average turnover, in the portfolio that tell me the manager did not do his homework. They are constantly chasing the next fad 4) Pick out the mutual fund families which close to new investors, more purchases of shares from existing investors when they have a superior year, and then everybody want to get into that specific fund. 4) Just like other investments, when it performance is below average for too long of a period for no valid reason – it is time to find a new investment, but find where you going to invest prior to selling. 6) I prefer small companies MF, and mid cap MF, and overseas MF. These investments are typically harder to investigate than large companies. If I invested in large company MF’s then I would consider buying stocks directly; but, probably would use mutual fund literature to select individual small and mid cap companies for both stock and to screen employment opportunities 5) I will probably never get out of MF unless something changes dramatically in that area., The better MF managers visit the plants, talk to the manager’s, talk to the competition, and go to the trade shows etc. That don’t just look at the written data provide by the news services.
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Victoria
Who is a good brick+mortar/online stock investment company if you are interested in investing in ETFs like the S&P 500 and QQQQ?
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typome
Hello Ramit, I was wondering what your thoughts are on ING's IRA and how they invest in their mutual funds? I normally wouldn't invest in mutual funds, but I do want to have an IRA. It's just that ING's IRA invests in mutual funds and not index funds. Do you think that is okay? Thanks for reading!
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jana
index funds also, at least where i live, have much less marketing/advertising. the actively managed ones use often very clever tactits to persiade you to buy them. probably for a reason.
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Lee Smith
The reason people invest in regular mutual funds instead of index funds is because they just don't know the difference. There is no press about it or it's not on the front page of the newspaper. Also, most people have a 401k from their job and if it is not offered in there than they will never invest in one. It would be a disadvantage to mutual fund companies to include it in retirement accounts because they would make less money per year on it.
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Sameer
Wonderful discussion... however I still feel consistent performing mutual funds will always outperform markets i.e. index funds. It is always about fund manager and investment policies.
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Kat Cramer
If you're family reveals they have a mutual fund for you is it possible to switch the money into an index fund? Also if you are headed to professional school should you let money sit in a mutual fund/ index fund until you make an income and use loans to pay for tuition? Or should you go ahead and start using the money in the fund to pay for tuition? The money does not cover the tuition in full.
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Shane
Good article! I'd like to comment one branding business tip that can "Help you get rich" and get your message to your target audience. The internet is the biggest player in the investing game nowadays. Networking, investor outreach, statistics, and most Invest Mutual work are done online. "I will teach you to be rich.com" is way too long of a domain name. A shorter name has countless attributes that I would love to breakdown for you, if you'd like. But for now I will try and keep this short. Invest.com sold for $X,XXX,XXX this week...Which makes sense because it is a short keyword term that could be used by many businesses in the financial industry. A name like InvestMutual.com at this point in time is not a $x,xxx,xxx name. It is however a short two keyword domain that could be used by many businesses in the financial industry. As more and more companies buy up exact keyword domains the prices will continue to rise, and the short sweet domains will be for those grand fathered in, or those with big checkbooks. InvestMutual.com is currently for sale for $X,XXX. Which is low for being short, strong, industry keywords. I wouldn't be shocked if it is a $XX,XXX name within the next 5 years. 5 years ago you could buy a four letter domain for $10-55. Today all four letter combinations are taken and range from $250-600. (with keyword four letters going for millions!) To sum it all up. I think if you are going to teach people how to be successful in the Mutual Investments world you should have a better domain name that is easier to remember, ranked better in google, and is EASIER FOR MORE INVESTMUTUAL (students) to find this site. Best Wishes to you all! Feel free to ask me ANY questions!
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David Purnell
You don't need a mutual fund to get just $800, which in my opinion is peanuts, for a $10k investment. Moreover, a lot of your profit will go to your "fund manager" and even if you don't make any profit, you will be charged a "maintenance fee." I would probably invest in any developing country's 1 year FD, which also gives you 7-8% returns, and is probably the most safest bang for your buck. They can also be compounded and you can also make some side money if you time the forex markets!!
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Future Millionaire
Thank you for this great blog. If i want to invest in an index, do you recommend a fund or an etf? Thank you in advance
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Shuchi
I hope, just like you read "each" email, you read "all" comments from readers. Has any of your reader ever written you that "I want to know about YOU Ramit"? Yes or no whatever, I am glad if you consider me the first one and serve my curiosity. Thank You!
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Samuel
Ramit, I love it, I agree, but I messed it up! Re-reading "I Will Teach You To Be Rich" made me double-check my Roth IRA and---dang it! I ignorantly 1) invested in a lifecycle mutual fund which 2) has a target date 20 years before I intend to "retire"! I now have found the correct *index* target date fund, and I will buy into that and start making automatic monthly investments. It has been only 2-3 years that I've owned my "not optimal" Roth IRA, so hopefully I'm still achieving the 85% Solution to my long-term finances. My question is... What should I do with the incorrect (no longer actively funded) mutual fund?
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Comments are closed.
chetan
Hi Ramit Excellent discussion above on index funds. One question is - what if you don't have enough to meet the min. investment needed to get into more than a few funds (so you want to access different index funds - not just the SP 500) . Say I have 10,000 dollars to invest. I can definitely do VFINX (Vanguard 500), and add one or two more. In contrast we have the fidelity 2040, which is an asset allocation fund. The expense ratio is 0.79, and i did not find any other expenses in the prospectus. The expense ratio is of course way higher than the SP (0.18), but I get more diversifcation. (BTW - it's interesting to note that if you buy from fidelity, there is an extra 0.16% mgmt fee. I didn't see that at Ameritrade). Maybe one could invest in the Fidelity 2040 to begin with, and then once we have enough $$ to diversify (and i mean diversify beyond the SP; Will Bernstein, Four Pillars of Investing - pg 272 shows a very diversified portfolio), one can make one's own portfilio of different index funds. Would appreciate your thoughts on this. thanks! c