Your Guide to Mutual Funds

What Are Mutual Funds?

Imagine you and your friends each put $10 into a bowl and that money gets combined and invested together. That's a mutual fund. It's basically a pool of money from multiple investors that is invested in stocks, bonds, and other securities (a tradable financial asset that holds monetary value).

When you buy a share of a mutual fund, you are buying a slice of all the investments that the fund owns. So instead of you buying individual stocks, you're buying fractions of dozens or even hundreds of different companies.

You may have heard of index funds, ETFs, or mutual funds, and they're all pretty similar. But there are a few key differences that are very important to understand so you can select what makes the most sense for your situation.

Who Runs Mutual Funds?

Mutual funds are run by professional money managers who make the decisions about which securities to buy and sell. They have years of experience researching and making trading decisions. This means you don't need to spend hours studying financial statements (though you should learn how!) or trying to pick the next winning stock for yourself.

Types of Mutual Funds

There are two main types of mutual funds: passively managed and actively managed funds. Passively managed funds, like index funds, try to track the performance of a market index (a benchmark that tracks the performance of a specific group of securities) rather than beat it. On the other hand, actively managed funds are run by teams of investment experts who want to beat the stock market's returns.

Unlike stocks that you can trade throughout the day, mutual funds only trade once per day after the markets close. The price per share is called the net asset value (NAV), which is calculated by adding up the total value of the fund's holdings, subtracting fees and expenses, and dividing by the number of shares.

Ways to Make Money With Mutual Funds

There are three main ways to make money from mutual funds:

So Are Mutual Funds Actually Good?

Mutual funds offer an easier way to diversify and access to professional management without needing to pick individual stocks, but they come with some trade-offs.

The biggest downside? Fees can impact your long-term returns. Even "low-cost" funds charge annual expenses, and for actively managed funds, these typically range from 0.50% to 1% or higher.

For example, let's say you invest $10,000 and it grows at 10% annually over 40 years. With a low-cost ETF charging 0.05%, you'd end up with about $442,000. But with a mutual fund charging 1% in fees? You'd only have around $318,000. That extra 0.95% in fees just cost you $124,000 — more than 12x your initial investment.

Investors also have limited control over the timing of taxes and can face capital gains taxes even if they didn't sell any shares. This happens when the fund itself sells investments and passes those gains along to you as a "distribution" — basically, your share of the fund's profits for the year, which the IRS treats as taxable income.

Differences Between ETFs and Mutual Funds

For many investors, low-cost ETFs might be a better choice because they offer similar diversification with lower fees and better tax efficiency. The main differences between the two come down to flexibility and cost. ETFs trade like stocks throughout the day, so you can buy and sell whenever the market is open. Mutual funds only trade once daily after the market closes. Additionally, ETFs typically have lower expense ratios, often under 0.10%, while mutual funds can charge 0.50% to 1% or more. Lastly, because of how ETFs are structured, you only get hit with capital gains taxes when you personally decide to sell, rather than getting surprise tax bills from distributions like you do with mutual funds.

Final Thoughts

Overall, mutual funds can be a solid investment option, especially if you want professional management and don't mind paying a bit more for it. But it's important to remember that these fees can add up significantly over time. Before investing in any mutual fund, check the expense ratio (the annual percentage fee a mutual fund charges shareholders to manage and operate the fund) and compare it to similar ETFs or index funds. Do your own research, understand what you're paying for, and decide what makes the most sense for your financial goals.

Written by Matthew Park, LRF Intern & Contributor