What Is a Mutual Fund?

A mutual fund is a type of financial vehicle that a professional money manager organizes.

Mutual funds, explained

With a mutual fund, the individual or firm in charge is responsible for allocating the fund’s assets in a way that produces profit for the fund’s investors. The purpose of a mutual fund is to give individual investors access to professionally managed portfolio of securities, rather than throwing them to the wolves (or into a pit of hungry financial advisors).

As with an ETF, the portfolio of a mutual fund should match the investment objectives – read: which indices, assets, or sectors make up the portfolio, and in what percentages. It’s possible for a mutual fund to contain hundreds of individual securities at once or only a few dozen. The makeup of a mutual fund means that every shareholder has a stake in the fund’s performance (losses and gains) in the same proportion they’re invested.

Typically, mutual funds invest in more than one type of security at a time – for instance, a single fund may hold stocks, bonds, and money market securities. Therefore, you can calculate a mutual fund’s performance by looking at each underlying investments' performance.

Unlike ETFs, mutual funds change price – and hands – only once per day. We mentioned above that open-end funds trade at the end of the trading day based on the NAV (Net Asset Value) of the fund. Mutual funds trade the same way. You can calculate the share price of the fund according to the NAV after markets have closed.

It’s important to note here that in an actively managed mutual fund, the manager(s) can trade assets within the fund intraday. However, you cannot make money trading shares of the whole fund throughout the day.

As a result, mutual funds are usually poor investments for day traders, but like ETFs, they are popular with many retirement funds, as they tend to generate average to generous returns on investment over a period of years.

Mutual funds come in three basic flavors:

  • Open-end funds generate and remove shares due to investor demand
  • Closed-end funds maintain a fixed number of shares that trade only as available
  • Unit Investment Trusts (UITs) are static portfolios with no management

What this means for you

The main advantage of mutual funds is that they allow everyday investors to (more or less) affordably purchase their way into diversified, professionally managed portfolios.

Over time, mutual funds can generate steady gains on investment within the fund. However, these benefits come at a steep cost: most actively managed mutual funds charge high fees that can negate returns.

Furthermore, mutual funds, unlike ETFs, are not the most tax-efficient investment vehicles. With a mutual fund, the money invested is only tax-exempt so long as the money remains within the fund. In the case that a mutual fund sells a particular security at a profit, the law requires that the money is reimbursed to the shareholders. They must then pay taxes on their capital gains – whether they wanted the gains or not.

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