What Are Mutual Funds and How Do They Work?

A mutual fund pools money from many investors and uses that money to buy a range of assets including stocks, and bonds. Mutual funds have become an increasingly popular investment due the reduction of risk through diversification, and the potential for strong returns.

As noted, mutual funds pool money from lots of investors to buy a variety of assets. If that still sounds confusing, think of it like this. Imagine that you were standing in a room full of investors and in the middle of the room there was an empty basket.

Each investor in the room could put a $100 into this empty basket. Therefore, you and all the other investors in the room mutually funded this basket. The collective funds in the basket would then be compiled together and used to buy a range of assets.

When you buy a mutual fund, you are not directly buying individual stocks and bonds. Instead, you are buying a share of the mutual fund. When you buy a share of a mutual fund, you have an ownership interest in the assets that the fund owns.

So, who gets to determine what assets the funds buy? Good question. In short, mutual funds are managed by a professional fund manager. This fund manager is in charge of buying and selling assets in line with the goals of the mutual fund.

Due to this, mutual funds often have an "active" investing goal. This might sound confusing, but it is actually quite simple. Mutual funds often have the goal of beating or outperforming the standard return of the stock market.

The stock market historically averages a 10% return over time (not every year of course). A mutual fund typically has the goal to beat this benchmark return by providing 11% or 12% returns. While this sounds nice, most mutual funds fail to accomplish this feat.

SPIVA Scorecard Data indicates that only 7.81% of actively managed mutual funds beat the standard return of the market over a 15 year time period. Passively managed funds, such as index funds, on the other hand simply aim to match or mirror the standard return of the stock market.

1. The mutual fund share price increases

The first way you can make money with mutual funds is when the price of the mutual fund's shares go up in value. Remember, you are not directly buying all of the investments that the mutual fund owns when you buy shares.

Instead, you gain an ownership interest in the assets that the fund owns. If the underlying investments that the mutual fund owns goes up in value, the share price of the mutual fund itself also goes up in value. If your mutual fund shares go up in value, you can cash in.

2. Income from stock dividends or bonds

If a mutual fund owns stocks that pay dividends or bonds that earn interest, the fund is required to pass those earnings onto you as a shareholder. These earnings are typically distributed on a regular basis which can be monthly, quarterly, semi-annually or annually depending on the mutual fund.

3. Capital gains when the fund sells an investment

Thirdly, if a mutual fund sells an investment for a capital gain (profit), you are entitled to those earnings as a shareholder of the mutual fund. For example, say that your mutual fund decided to sell 10% of its stock holdings for a profit.

This profit is referred to as a capital gain. A mutual fund will typically distribute these capital gains to you once per year at a minimum. Although capital gains earned from a mutual fund can boost your returns, it can also create a bit of a tax problem - we will look at this later on.

Mutual funds need to generate revenue in order to cover their necessary operating expenses and to pay their fund managers. There are two main fees to be aware of.

1. Shareholder fees

As the name implies, shareholder fees are fees that a mutual fund will charge you the shareholder in order to cover a variety of expenses. There are five shareholder fees to be aware of. a) Sales loads - A sale load is a fee that you pay to the broker that you bought shares of your mutual fund through.

It is essentially a sales commission. For example, if a mutual fund had a load fee of 5%, you would be charged a $50 fee when you bought $1,000 worth of shares. Mutual funds that charge this type of fee are called load funds.

Load funds can either charge an upfront or deferred sales load fee. So, you will either pay a load fee when you purchase shares of your mutual fund (upfront), or you will pay a load fee when you sell shares of your mutual fund (deferred).

On the flip side, there are some mutual funds that do not charge a sales load fee, and are therefore referred to as no-load funds. However, no load mutual funds make up for this by charging fees in other ways (see below).

b) Redemption fee - A redemption fee is similar to a deferred sales load fee that a load fund charges and is charged when you "redeem" shares of your mutual fund. However, there is one key difference. Unlike a load fee that is paid to a broker, a redemption fee is paid directly to the fund to cover its costs when you redeem shares.

c) Purchase fee - A purchase fee is similar to a front end sales load fee. It is a fee that is charged when you purchase shares of a mutual fund. Unlike a load fee that is paid to a broker, a purchase fee is paid directly to the fund to cover its costs when you purchase shares.

d) Exchange fee - An exchange fee is a fee that is charged if you exchange or transfer your shares from your current mutual fund to another mutual fund within the same fund group. e) Account fees - Finally, some funds will impose an account fee which relates to the maintenance of your account that you hold your mutual funds in.

Account fees are often charged when you do not have a minimum account balance required by the fund in order to avoid fees. For example, if your account balance dropped below $10,000, you could potentially be charged an account fee.

2. Fund operating expenses

In addition to the shareholder fees that you can incur above, mutual funds also charge operating expense fees to cover the costs of running the fund.

a) Management fees - Management fees are paid out to the professional fund managers who run the fund. a) Distribution fees - Distribution fees are fees that a fund may charge in order to cover the expense they incur when distributing income or capital gains to you as a shareholder.

c) Other expenses - These are fees charged by mutual funds in order to cover costs outside of management and distribution. This can include custodial costs, legal costs, and administrative costs. c) Total annual fund operating expense - This is the total operating fee that a fund charges by combining the fees listed above.

3) What are the total fees you will pay?

It depends on the mutual fund that you invest in, but expect to pay between 0.5% to 2% per year in fees. Higher fees will eat into the dollars you invest and lower your overall return. When you are looking to invest in a mutual fund, remember to consider all fees associated with the fund.  

Mutual funds are taxed based upon capital gains which can occur in three different places. These rules are applicable if you buy mutual funds through a taxable brokerage account. You can avoid some of the taxes associated with mutual funds by buying them through tax advantaged accounts (see item 5).  

1. Taxes on income earned from stock dividends and bonds

If you invest in a mutual fund that earns income from stock dividends or bonds, your portion of the income earned is subject to taxes. The income that you earn from bonds is taxed at your ordinary income rate. The income that you earn from dividends will be taxed at your ordinary income rate if it is a nonqualified dividend.

The income you earn from dividends will be taxed at long term capital gains rates (more on that below) if it is a qualified dividend. You will typically be sent an IRS Form 1099-DIV that will show how much income you earned. You are required to report this income when you file your taxes. ‍

2. Taxes on capital gains distributions

When your mutual fund incurs a capital gain by selling investments within the fund for a profit, your portion of these profits (distributions) are subject to capital gains tax. You will typically be sent an IRS Form 1099-DIV that will show how much you earned through capital gains distributions. You are required to report this income when you file your taxes.

3. Taxes when you sell shares of your mutual fund

Thirdly, you can incur capital gains tax when you sell shares of your mutual fund for a profit. The price of shares in a mutual fund typically increase when the underlying assets the fund owns increase in value. If you want to sell your mutual fund shares to other investors for a profit, you are able to do so.

4. What are capital gains and their tax rates?
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For clarity, a capital gains tax is simply a tax on the profit you make when you sell an asset, and is how mutual funds are taxed. If you sell an asset at a loss, you have a capital loss and do not owe any taxes. You can incur either a short or long term capital gains tax.

A short term capital gains tax occurs when you hold an asset for less than a year before selling it. Short term capital gains tax rates are the same as your ordinary income. A long term capital gains tax occurs when you hold the asset for more than a year before selling it.

Long term capital gains rates are more favorable as you will pay 0%, 15% or 20% depending upon your tax filing status and income. You can use the chart below to get an idea of what long term capital gains rates could look like. Simply find your tax filing status and corresponding income to see what rate you could incur.

(Accurate for 2024).

5. Strategies to reduce mutual fund taxes

a) Hold mutual funds in tax advantaged accounts

The easiest way to reduce the taxes associated with mutual funds is to buy mutual funds through tax advantaged accounts. The most popular of these accounts for the typical investor would be IRAs (individual retirement accounts, and employer sponsored 401(k)s.

These account types offer either tax deferred or tax free benefits. A Traditional IRA and 401k offer a tax deferred benefit. Essentially, you don't pay taxes on the dollars you invest today, but wait or defer the taxes until you pull the money out in retirement.

So, if you bought mutual funds through a tax deferred account, you would not owe any taxes on any of the income, capital gains, or increases in share price until you pulled the money out in retirement, at which point you would incur taxes at your ordinary income rate.

On the other hand, a Roth IRA and 401k offer tax free benefits. You contribute to these accounts with dollars that have already been taxed, but then the investments within your account grow tax free and when you pull the money out in retirement you don't owe any taxes.

So, if you bought mutual funds through one of these accounts, you would pay taxes on the dollars you contributed to the account, but you would not owe any taxes on any income, capital gains, or increase in share prices when you pull the money out of the account in retirement.

Learn more about these accounts

b) Buy mutual funds with low turnover ratios if you hold them in a brokerage account

A turnover ratio is simply the percentage of assets that has been replaced in 1 year. For example, a mutual fund with a turnover ratio of 25% replaced 25% of its assets during the year. If you buy a mutual fund with a high turnover ratio in a brokerage account, you could incur high capital gains tax.

Remember, when your fund manager sells assets for a profit, those earnings are distributed to you and you are taxed accordingly. If a mutual fund has a high turnover ratio, it means they are actively buying and selling lots of assets which can increase the likelihood that you will owe taxes.

If you buy mutual funds through a tax advantaged account, you don't have to worry quite as much about the turnover ratio as the accounts will protect against the capital gains through either tax deferred or tax free benefits.

c) Wait for more than a year before selling shares

In order to get a more favorable capital gains tax rate, you can wait until you have held shares of your mutual fund for a minimum of 1 year. This will get you into the lower tax rates of 0%, 15% and 20% as opposed to being taxed at your ordinary income tax rate. Again, this applies if you hold your mutual funds in a brokerage account.

d) Understand what your mutual fund invests in

You should also understand what your mutual fund invests in. If your mutual fund is highly invested in assets that produce income such as dividend stocks and bonds, you might want to avoid that fund if your goal is to reduce taxes.

e) Seek out tax experts

Most importantly, you need to seek out tax experts. Taxes associated with mutual funds can get confusing. It is important that you understand the tax implications of your investments, as well as how to be tax efficient. You can speak with a CPA or financial advisor for more clarity.

1) Diversification

Mutual funds lower the risk associated with investing through diversification. Since a mutual fund holds lots of different assets, it can typically recover when a few assets underperform. In other words, you get exposure to lots of different assets all at once.

2) Strong returns

In general, mutual funds tend to provide reasonably strong returns which can grow the money you invest over time due to compound interest. Depending on what the mutual fund invests in, you can reasonably expect a 9% to 10% return over time.

It is worth noting that these returns do not happen every year as the mutual fund will fluctuate in value as the assets it holds fluctuates in value. However, over the long run, the assets in a mutual fund tend to recover from down turns.

You can expect at least a return of 8% to 10% per year (averaged over long periods of time) when you invest in mutual funds. Keep in mind that most mutual funds often have the goal of beating the standard return of the market. Also keep in mind that average returns often differ from actual returns.  

Although very few fund managers are able to pull off the feat (less than 8% per year over a 20 year period), it is possible to invest in a mutual fund and experience returns higher than average, such as 11% , 12% or even 13% returns.

3) Easy to invest in

Mutual funds are easy to invest in. You simply open your investing account at a broker, transfer funds from your bank account, and then buy shares of your chosen fund. Additionally, since mutual funds are managed by professional fund managers, you do not have to worry about choosing individual investments, or when to buy or sell investments.  

1) High fees

When compared to passively managed investment funds such as index funds, mutual funds do tend to have higher fees. Mutual funds tend to have higher fees than other types of investment funds as the fund managers who run the fund need to be compensated.

The idea of course is that the fund manager can get you a higher than average return. Although this is nice in theory, not many fund managers pull off the feat over long periods of time. Also keep in mind that you may be charged other fees outside of management fees such as sales loads.

2) May underperform passively managed investment funds

The biggest risk to investing in mutual funds is that they may underperform passively managed investment funds. Remember, mutual funds are "active" due to the fact they have a fund manager. Passive investment funds, such as index funds, are not actively managed by a professional investor.

Due to this, passive investment funds try to match the average return of the stock market and often have lower fees than actively managed mutual funds. If you were to invest in an actively managed mutual fund that failed to beat the market, you would be worse off than if you would have invested in a passive fund.

For example, lets say that you invested in a mutual fund with hopes to get an 11% return which would beat the market. Lets also assume that the fees for the mutual fund were 0.50% per year. The alternative would be to invest in a passively managed fund with hopes of a 10% return minus fees of 0.25% per year.

After you invested in the mutual fund, the fund only provided a return of 10% - meaning it failed to beat the market return. After subtracting out fees, you would be left with a return of 9.5%. If you would have invested in the passively managed fund, you would be in a better spot with a return of 9.75% (10% return - 0.25% fee).

3) Tax problems

As previously discussed, mutual funds can create some capital gains tax problems. You can be subject to pay capital gains tax on any portion of income or distributions you receive as a shareholder. You can also incur capital gains tax when you sell shares of your mutual fund for a profit.

There are ways to minimize these tax problems. You can buy mutual funds through tax advantaged investment accounts, buy funds with a low turnover ratio, and wait for more than a year before selling shares to get a more favorable tax rate.

We always recommend speaking with a professional tax expert if you need help understanding the tax implications of mutual funds.

There is not necessarily a "best" investment. A better question to ask yourself is if mutual funds are a good investment for you? The answer to that will vary greatly. Mutual funds are typically used to build investors portfolios that plan to invest for long periods of time -such as an investor saving for their retirement. Why is this exactly?

a) Mutual funds are less risky than individual assets due to diversification. Since a mutual fund owns lots of different stocks, bonds, etc., you are not reliant on just one or two assets to get you to where you want to be.

b) Mutual funds are convenient and easy to invest in. You do not have to worry about picking individual investments and get the added benefit of a professional fund manager (as long as they can help the mutual fund perform well).

c) Mutual funds do provide good returns over time. You can expect to get between 8% to 12% per year depending upon what mutual funds you buy. Keep in mind that mutual funds do not increase in value every year, but they tend to do well if you hold them for long periods of time.

The bottom line is that mutual funds may be a good investment for you if you want a "safer" investment option that will provide stable returns if you hold onto them for long periods of time.  As previously noted, mutual funds are not perfect.

You can run into high fees, tax problems, and the risk of reduced performance when compared to passively managed investment funds. At the end of the day, mutual funds may or may not be a good investment for you. It depends upon your individual circumstances.

We recommend speaking with a licensed financial advisor if you need help figuring out if mutual funds are right for you.

The process of buying mutual funds is quite simple. You can do it through an online broker. The first step is to open an investing account through your chosen broker. (You can check out our list of the best online brokers if you need help finding one).

Once you have chosen a broker, simply go through an online application for an investing account. At a bare minimum, you will need a brokerage account, but it might be better to buy mutual funds through an IRA to avoid some of the tax problems. (Check out our list of the best investing accounts for more information.)

After your account is approved, transfer funds from your bank account to your investing account. From there, you can research mutual funds that you want to invest in. Most brokers offer free tools to help you compare the best mutual funds.

Once you find a mutual fund that you want to invest in, you need to execute a trade. This might sound complicated, but it is not.  You simply need to search for the ticker symbol of the fund you want to invest in, select a dollar amount to invest, and execute the trade.

A ticker symbol is simply just a series of letters and numbers that represent a particular investment. For example, the T. Rowe Price US Equity Research Fund ticker symbol is PRCOX. If you wanted to buy this fund, you could search for the ticker symbol and execute a trade.

Mutual funds pool resources from many different investors to buy a range of stocks, bonds and other assets. When you buy shares of a mutual fund, you do not directly own the assets that the fund owns. Instead, you have an ownership interest in the assets the fund holds as the fund shareholder.

You can make money off of any income or capital gains the mutual fund earns, as well as the sale of your shares for a profit. However, each of these could potentially create a tax liability if you hold mutual funds in a brokerage account.

Mutual funds have pros and cons. They are easy to invest in, can potentially provide strong returns, and allow you to easily diversify. On the flipside, they can have high fees, they might underperform in comparison to passively managed funds, and tax problems can arise depending on a variety of factors.

At the end of the day, mutual funds may or may not be a good investment for you. It depends upon your individual circumstances and what you are trying to accomplish. You can speak with a licensed financial advisor for more advice, or open an investing account at an online broker to start researching potential funds to invest in.