What is a Mutual Fund and How Does it Work?

When it comes to investing your money, the more questions you ask, the better. Never shy away from asking people who have experience.

If you are unsure of starting on your own, investing your money in mutual funds means you will not be doing it all by yourself.

What is a Mutual Fund

A mutual fund is a combination of investment by professional money managers. These fund managers use funds pooled from many people to invest in securities like stocks, bonds, money market instruments, and other assets. Investing in a mutual fund helps you reduce risk by making multiple investments.

Mutual funds give you access to professionally managed portfolios of equities, bonds, and other securities. As an investor or shareholder, you participate in one way or the other in the fund’s gains or losses. It means you will be able to invest in securities you would not have had access or capacity to invest in. The difference here is you are doing it with other investors this time.

Mutual funds put resources into countless securities, and execution is typically tracked as the change in the asset’s total market capitalization – derived by the accumulating performance of the underlying investments.

The U.S. Securities and Exchange Commission defines a mutual fund company as…

 “A company that pools money from many investors and invests the money in securities such as stocks, bonds, and short-term debt. The combined holdings of the mutual fund are known as its portfolio. Investors buy shares in mutual funds. Each share represents an investor’s part ownership in the fund and the income it generates.” 

Now let’s look at how mutual funds work and their role in your savings and investment goals.

How Mutual Fund Works

When you invest in a mutual fund, you invest in a compilation of investments owned by you and other investors managed by professionals. It is essential to know that some mutual funds have objectives. The mutual fund’s investment objective will determine the type of securities the professional managers will buy on your behalf. 

For instance, a mutual fund may focus on investing in stock from large firms, government bonds, or stock from other countries. The objective can also be to invest in a variety of investments.

When you put your money in a mutual fund, you join other investors to buy the fund’s units or shares. The more people invest, the more units or claims will be sold. 

These professional money managers manage the portfolios in the pooled funds. They do this daily, making critical decisions on when to buy or sell investments according to the fund’s objective.

Mutual funds companies are registered with the Securities and Exchange Commission or SEC. Your investment buys you shares in the fund. You can buy directly from the mutual fund company or through investment professionals. Each unit you own represents your percentage of ownership in the mutual fund portfolio.

How You Make Money from Mutual Funds

How You Make Money from Mutual Funds

You can start making money from your investment in mutual funds within days.

Suppose the mutual fund company sells securities in the year and makes a profit. In that case, it is called a capital gain, and when it makes losses, it is called capital losses.

The company can decide to distribute those gains after deducting capital losses to its shareholders at the end of the year. Also, securities in the portfolio may pay dividends, which may be distributed to investors.

Your share value increases as the market value of the mutual fund’s portfolio increases. Although, that remains on paper or online as the case may be and not in your pocket. You get to enjoy this appreciated value when you sell your shares or units at a higher price.

When you make capital gains on your shares, you have the option of asking to be paid via transfer or check. Alternatively, you can invest your payoff to buy more shares in the fund. The choice is yours.

With mutual funds, you can diversify your investment with ease than trying to do it yourself directly. And this might mean less risk for you than investing all your money in some schemes out there.

Features of Mutual Fund

It is crucial to understand how mutual funds are different from other types of investment in the marketplace.

Professional Management

Those professional money managers who work with the mutual fund company charge fees for their services. The funds you invest in can be either actively or passively managed.

Professionals who manage active funds buy and sell investments daily to maximize the fund’s performance. In other words, they try to make money for you, but there’s no assurance they will succeed. Actively managed funds attract higher management fees because you are essentially paying for the expertise of the manager.

Passively managed fund managers don’t try to beat the market to provide investors with short term returns. These managers are less aggressive in the management of these funds. Management fees for passively managed funds are lower than actively managed funds.

Share Classes

Some mutual fund companies allow you to showcase your experiences by choosing from different categories of shares. Each class comes with its fee and expenses, and they perform differently. Bear in mind that your broker or professional fund manager may be paid separate payments for each class of shares they sell.

Mutual Fund Fees

Mutual Fund Fees

Mutual fund companies tend to classify expenses into shareholder’s fees or annual operating fees. 

Annual Operating Fees

As the name suggests, annual operating fees are usually between 1 to 3% of the fund under management and charged yearly. Annual operating fees are also called expense ratios. That is the summation of a fund’s administrative cost and advisory or management fees.

Shareholders Fees

Shareholders’ fees are redemption fees, commission, and sales charges. They are paid directly by you as an investor when purchasing or selling the funds. These charges are also known as “the load” of a mutual fund.

Types of Loads

Mutual funds have two different types of loads. When you pay for the fees associated with your investment while purchasing the fund, it is said to be a front-end loan. For back-end load, mutual fees are accessed when you sell your shares.

In some scenarios, some investment companies offer a no-load mutual fund. These types of funds don’t carry any commission or charges. They are distributed directly by the mutual fund company and not through a 3rd party. Some funds will also charge you penalties for “early withdrawal” or selling before the time expires.  

Types of Mutual Funds

There are lots of funds out there for you to choose from, and you base your decision on any factor that best suits you. These factors include sector, returns, risk level, geographic area of investment, and more. For instance, your decision may be based on funds made for medical service, emerging markets, to even another country.

These funds make up a portfolio. Each one has its benefits, shortcomings, and conditions before you can invest in them. 

We will review some of these funds and see what options you can choose from when you’re ready.

Money Market Funds

These are short term investment securities issued by the government or corporations, usually for less than a year. The U.S. government, through the U.S. Treasury, issues securities like C.D.s. Corporations, on the other hand, issue commercial papers. These types of funds have the lowest returns and the lowest risk too.

Fixed Income Funds

This type of fund focuses on investments that pay a specific set of returns. They are investments like government bonds, corporates bonds, and other debt instruments. The fund portfolio generates fixed interest payments, which it passes on to shareholders.  

Note that all bonds are affected by interest rates. The higher the rates, the lower the value of the fund.

Equity (Stock) Funds

These are funds invested in buying stocks of different companies. They come in different capitalization sizes.


For buyings stock of blue-chip companies like Apple, Google, Amazon, and others. These companies have market capitalization valued at over $10 billion.


For stocks in non-blue-chip companies, like mid-level companies with a market cap between $300 to $2 billion.


The focus here is on Startups and smaller companies, and they are mostly risker.

Balanced Funds

Balanced Funds are also known as allocation funds. It’s a hybrid of asset classes like money market instruments, bonds, stocks, and other alternative investments. The purpose is to reduce the risk across asset classes.

Indexed Funds

The investment strategy here is based on the fact that it is near impossible to beat the market all the time. It even costs more to try to do that regularly. So, the index fund manager purchases stocks related to a major market, such as the S&P 500 or the Dow Jones Industrial Average (DJIA). 

This methodology requires less research from analysts, so it is less expensive to gobble up returns before they are passed on to investors. These types of funds are planned with cost-sensitive investors in mind. Index funds are, for the most part, no-load investments.

Income Funds

The main objective of income funds is to provide a regular and steady income for the investor. The investors targeted by Income funds are conservative investors like veterans and retirees. This set of investors are mostly concerned about regular income. If you are tax-conscious, this may not be the right investment for you.

Income funds invest mostly in government and high corporate debts, and holding these bonds until maturity will provide interest streams.

International/Global Funds

An international fund (or foreign fund) invests in assets situated outside the shores of your home country. On the other hand, global funds can invest anywhere around the world, including your home country.

Trade Traded Funds (ETFs) 

These well-known venture vehicles pool investments and use systems consistent with mutual funds. They are organized as investment trust traded on stock exchanges and have the additional advantages of stocks’ features. 

For instance, ETFs can be purchased and sold anytime all through the exchanging day. ETFs can likewise be undercut or bought on margin. ETFs also regularly carry lower charges than the equal mutual fund. 

Numerous ETFs also benefit from active options markets, where investors can hedge or use their positions. ETFs also enjoy tax advantages. Contrasted with mutual funds, ETFs will, in general, be savvier and more liquid. The universality of ETFs speaks to their flexibility and convenience.

Specialty Funds

This mutual fund class is an all-encompassing class that consists of popular funds that don’t belong to any previously mentioned types. These funds are more targeted at a particular sector of the economy than the broader classes earlier mentioned. Sector funds concentrate on specifics like the Health, financial, or technology sector.

Sector funds are highly volatile because the funds in a given sector tend to correlate with each other. There are chances of great capital gains. However, the risk of losing it all is also there. A good example is the crashing of the financial sector in 2008/2009, and recently, the aviation, hospitality, and entertainment sectors in 2020.

Pros and Cons of Mutual Funds

Pros and Cons of Mutual Funds

The Mutual fund is the most popular in the U.S. today. There are various advantages to mutual funds. It is significant to examine the drawbacks, just as your requirements, objectives, and risk comfort, to decide if mutual fund investment is ideal for you.

Pros of Mutual Funds

There are reasons why mutual funds have been the retail investors’ choice for many decades. Let’s look at some of them.


Mutual funds spread their property over various diverse investment vehicles, which lessens the impact any single security or class of securities will have on the general portfolio. Since mutual funds can contain hundreds or thousands of securities, you would not be bothered if one of the securities doesn’t perform well as an investor.

One of the oldest investment advice you will find out there is to diversify your investment. It will help enhance your portfolio’s return while at the same time, reducing your risk. This is what a mutual fund offers you. Purchasing singular organization stocks and offsetting them with industrial sector stocks, for instance, provides some diversification.

Professional Management

Pros of mutual funds - professional management

Years ago, when I wanted to invest some money, I didn’t have the financial know-how. I couldn’t keep up with all the analysis and other information. So because I could not decide on which way to go, I ended up keeping the money in the bank for more than a year. 

Mutual funds are managed by professionals who dedicated their careers and expertise to help investors receive the best risk-return on their investment. They have a wide range of experience to know how to analyze and pick stocks they anticipate will perform well. They have a vast knowledge of information arising from in-depth research. That’s what you get from investing in a mutual fund.


Mutual funds can be traded daily. Although not as liquid as the stocks, which can be traded intraday, buy and sell orders are filled after market close. 

Unlike other rigid investment schemes that limit access to your funds with strict rules, mutual funds allow you to redeem your units or shares on business days. The company will send your payment to you within seven business days.


If you don’t have the time to micromanage your investment portfolio, I strongly recommend mutual funds. If you intend to invest on your own, you will probably spend a lot of time researching various securities. To acquire a vast and wide range of holding similar to mutual funds will cost a lot and tie-down your funds. You also have to monitor all these funds on your own. Suppose you choose to engage the service of a professional manager on your own. In that case, it will cost a lot more when you compare it with fees involved in mutual funds investments.

Reinvest Your Dividends

You can grow your investment in a mutual fund without putting down additional dollars and incurring extra fees. This you can achieve by reinvesting your dividends and interest in additional fund shares. This way, you get to grow your portfolio with minimal transaction fees.

Investment Options and Objectives

With mutual funds, you can measure your risk. For instance, there are investments for aggressive investors. There’s the one that caters to risk-averse individuals. There are investment funds for people like me, the middle-of-the-road investors, like balanced funds, emerging market funds, and investment-grade bond funds.

No matter what investment style you prefer, you will find a mutual fund that suits your need. For example, there’s a life cycle fund to reduce risk as you near retirement. There are funds you can buy and hold and others in and out of holdings almost daily.


Perhaps this is the most crucial advantage of mutual funds. For as little as $40 per month, you can own shares in Amazon (NASDAQ: AMZN), Berkshire Hathaway (NYSE: BRK.A), and many more other high-end securities through mutual funds. At the time of this writing, a share of Amazon cost $3,185.02. 

Cons of Mutual Funds

There are various mutual funds out there, but it may not be the right form of investment for you. Here are a few demerits of mutual funds.

Fluctuating Returns

Mutual funds are like other investments where you don’t have a guaranteed expected return. The risk of fund depreciating is ever-present. Equity mutual funds suffer fluctuations just as the stock that makes up the fund. 

Every investment comes with its own risk. So, you need to be aware that mutual funds, unlike their bank counterparts, are not backed up by the Federal Deposit Insurance Corporation (FDIC). Also, there’s no guarantee of the performance of any fund.

Idle Cash

Mutual fund companies keep a large proportion of the investment pool in cash. This they do to satisfy share redemptions. We have people putting money in and others withdrawing daily. So, the company needs to keep a huge chunk of cash to accommodate the withdrawal request. While this is good for liquidity, the money is not working for you nor the company.

This cash that is just sitting and doing nothing for you is what we call drag cash or idle cash.

Capital gain Tax

Anytime the fund distributes gains made from selling individual holdings, you will be charged capital gains tax. It doesn’t matter if you are yet to sell your shares. If the fund experiences high turnover or sells holding more often, the capital gains distribution could be an annual event. 

The exception to all this is if you’re investing through a Roth IRA, traditional IRA, or employer-sponsored retirement plan like 401K.

High Cost

Mutual funds give investors professional management, but it’s not free. It comes at an expense ratio discussed earlier. These expenses eat into the overall payout or capital gains. Mutual fund investors pay all associated fees irrespective of the performance of the fund.

So imagine if the funs experiences streak of losses. The professional fund managers will still take out their fees—all these on the already suffering fund. Even when the fund is performing well, these fees are applied first, and you are paid what’s left.

Fees vary from one fund to the other. Failure to pay attention to them will eat deeply into your investment in the long run. Some very active funds incur transaction cost that accumulates over the year.

Vanguard is well known for their industry leading low fee funds, with some of them as low as 0.04% expense ratio per year. Lately, companies like Fidelity and TD Ameritrade have also followed suit with their own mutual funds that have extremely low fees.


We have mentioned earlier that diversification is a great advantage of mutual funds. On the other hand, mutual funds can fall into the pitfall of over-diversification. It’s like a sliding scale. The more securities you have in your portfolio, the less you will feel the overall impact. Actually, the less you will be able to manage them effectively.

With so many securities in your portfolio, your risk level will be reduced. That is correct. At the same time, your earning potential is reduced too. 

Lack of Liquidity

You can request for your shares to be converted to cash, but in most cases, redemption can only take place at the end of each trading day. That is in contrast to stock, where you convert your stock throughout the day.


As you begin to decide on your investment options, especially in mutual funds, start by evaluating yourself. What are your needs and goals? What do you intend to achieve, and how soon? What’s your comfort with risk, and what are your objectives?

Your responses to these questions will narrow your decision to a few options from the funds discussed. If you want to talk more about your options, reach out to me via the comment section. Let’s rub minds and share experiences.

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