Building a diversified investment portfolio can be difficult when purchasing individual stocks and bonds requires ongoing research, capital, and portfolio management. Mutual funds address this challenge by pooling money from multiple investors and using that combined capital to purchase a portfolio of securities based on a defined investment objective.

Mutual funds remain widely used in 401(k) plans, 403(b) accounts, IRAs, taxable brokerage accounts, and other investment accounts. They can provide access to diversified portfolios without requiring investors to research and purchase every underlying security individually.

Although exchange-traded funds (ETFs) have become increasingly prominent, mutual funds continue to play an important role in long-term investing, retirement planning, income generation, and asset allocation.

What Is a Mutual Fund?

A mutual fund is an investment company that pools money from investors and uses that capital to purchase securities such as stocks, bonds, money market instruments, or other investments. Each fund operates according to a stated investment objective and strategy.

When an investor purchases mutual fund shares, the investor owns a proportional interest in the fund's portfolio rather than directly owning every individual security held by the fund.

How Mutual Fund Shares Work

Mutual funds issue shares to investors. The value of those shares changes based on the market value of the securities held inside the portfolio.

For example, an equity mutual fund could hold hundreds of stocks across different industries. Instead of purchasing each stock separately, an investor can purchase shares of the mutual fund and gain exposure to the fund's underlying portfolio.

This structure can simplify portfolio diversification, retirement investing, asset allocation, and long-term investment management.

Net Asset Value and Mutual Fund Pricing

Mutual funds generally calculate their Net Asset Value (NAV) once each business day after the markets close.

NAV is calculated by taking the fund's assets, subtracting liabilities, and dividing the result by the number of outstanding shares.

Unlike publicly traded stocks and ETFs, mutual fund shares generally do not trade continuously throughout the trading session. Orders submitted during the day are typically executed at the next calculated NAV, subject to the fund's transaction rules and applicable deadlines.

This end-of-day pricing structure is one of the fundamental differences between mutual funds and ETFs.

Active and Passive Mutual Funds

Mutual funds can use different investment strategies, but two broad categories are actively managed funds and passively managed index funds.

Passive Index Mutual Funds

Index mutual funds attempt to track a specific market benchmark rather than having a portfolio manager select investments with the objective of outperforming that benchmark.

Examples include funds designed to track broad stock-market indexes or bond-market indexes.

Because index funds generally require less active security selection and portfolio research, many have relatively low expense ratios. Investors should still review each fund's actual costs rather than assuming every index fund is inexpensive.

Actively Managed Mutual Funds

Active mutual funds use portfolio managers and research teams to select securities according to the fund's investment strategy.

An active fund may focus on large-cap stocks, small-cap stocks, international equities, corporate bonds, government bonds, dividend-paying companies, or specific industry sectors.

Active management can involve greater research and trading activity, which may contribute to higher operating expenses. Some funds also charge shareholder fees or sales loads, depending on the fund structure and share class.

Understanding Mutual Fund Fees

Investment fees can have a significant effect on long-term portfolio growth because expenses reduce the portion of investment returns retained by shareholders.

The primary cost to examine is the expense ratio, which represents the fund's annual operating expenses as a percentage of its assets.

Investors should also check for:

  • Sales loads associated with purchasing or selling certain fund shares
  • Redemption fees that may apply under specific circumstances
  • Account or shareholder service fees
  • 12b-1 fees, where applicable
  • Minimum investment requirements
  • Differences between institutional and retail share classes

A fund with a low share price is not necessarily inexpensive. Comparing the expense ratio and other shareholder costs provides a more useful picture of the ongoing cost of ownership.

Mutual Funds vs. ETFs

Both mutual funds and ETFs can provide diversification by holding a portfolio of securities, but their trading structures differ.

Trading and Pricing

ETFs trade on stock exchanges throughout the trading day, allowing investors to place market, limit, and other types of orders.

Mutual funds generally transact once per business day at the applicable NAV.

Dollar-Based Investing

Mutual funds commonly allow investors to contribute a specific dollar amount through automatic investment programs. For example, an investor might direct $250 from each paycheck into a mutual fund.

This can simplify recurring contributions because investors do not need to determine how many whole ETF shares to purchase.

Many brokerages now also support fractional ETF shares, however, so this distinction is less significant than it once was.

Capital Gains Distributions

Mutual funds can distribute capital gains generated by portfolio transactions to shareholders. Investors holding funds in taxable brokerage accounts may owe taxes on these distributions even when they did not sell their own shares.

ETFs can have structural tax advantages in certain circumstances because of their creation and redemption process, although tax treatment varies by fund and investor circumstances.

Investors should therefore consider tax-efficient investing, capital gains distributions, and asset location when deciding where to hold mutual funds.

Mutual Funds in Retirement Accounts

Mutual funds are particularly common in employer-sponsored retirement plans.

A 401(k) investment account may offer a selection of stock funds, bond funds, target-date funds, and other investment options. Similar structures may appear in 403(b) plans and other employer-sponsored retirement arrangements.

Mutual funds can also be purchased through individual retirement accounts and taxable brokerage accounts, depending on the brokerage platform and available investment options.

When selecting investments inside a retirement account, investors should evaluate the fund's investment objective, expense ratio, historical volatility, diversification, and role within the broader portfolio.

How to Evaluate a Mutual Fund

Before purchasing a mutual fund, review several characteristics rather than relying solely on historical returns.

1. Identify the Investment Objective

Determine whether the fund invests primarily in U.S. stocks, international stocks, bonds, money market securities, or a combination of assets.

The fund should serve a specific role within the portfolio.

2. Review the Expense Ratio

Compare the fund's expense ratio with comparable funds pursuing similar strategies.

A difference of even a fraction of a percentage point can affect long-term investment results because expenses are deducted from fund assets over time.

3. Examine the Portfolio

Review the fund's holdings, sector exposure, geographic allocation, bond quality, maturity profile, and concentration.

Two funds with similar names can have substantially different portfolios and risk profiles.

4. Check the Fund's Tax Characteristics

For investments held in a taxable brokerage account, examine historical capital gains distributions and turnover.

High portfolio turnover can potentially create additional taxable distributions.

5. Consider Minimums and Share Classes

Some mutual funds require minimum initial investments, while others have low or no minimums depending on the brokerage platform and share class.

Institutional share classes may have different expense structures from retail versions of the same or similar fund.

Building Mutual Fund Contributions Into a Long-Term Plan

Once an appropriate fund has been selected, consistent contributions can simplify long-term investing.

Automatic contributions through payroll deductions, recurring bank transfers, or brokerage investment programs can help investors maintain a regular investment schedule.

Investors should periodically review whether their asset allocation, retirement contributions, investment fees, and risk exposure still match their financial objectives.

Mutual funds are not guaranteed investments. Stock funds can lose value during market declines, while bond funds can experience losses when interest rates, credit conditions, or other market factors change. Understanding these risks is essential before investing.

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