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Discover how mutual funds function, see practical examples, and learn to grow your investments wisely.

Mutual Funds: How It Works and Examples

Disclaimer: This website and its content are for informational purposes only and is not financial advice.

What Exactly Are Mutual Funds?

At its core, a mutual fund is a professionally managed investment fund that pools money from many investors to purchase securities like stocks, bonds, short-term debt, and other investments.

When you invest in a mutual fund, you are essentially buying shares in a collective portfolio. This collective ownership means that you share in the gains and losses of the fund's underlying investments. The combined holdings of the mutual fund are known as its portfolio.

The primary appeal of mutual funds lies in their ability to offer diversification and professional management, features that can be challenging and costly for individual investors to achieve on their own.

Instead of meticulously researching and buying individual stocks or bonds, you can invest in a single mutual fund that holds a wide array of these assets. This pooling of resources allows investors to participate in a broader market with a relatively smaller initial investment.

How Mutual Funds Work

The operational mechanism of mutual funds is quite straightforward. When investors contribute money to a mutual fund, a fund manager, or a team of professional money managers, takes this pooled capital and invests it according to the fund's stated investment objective.

This objective is clearly outlined in the fund's prospectus, a legal document that provides detailed information about the mutual fund.

The fund manager continuously monitors the market, conducts research, and makes decisions on which securities to buy and sell within the mutual fund's portfolio. The value of your investment in a mutual fund is determined by its Net Asset Value (NAV) per share.

The NAV is calculated at the end of each trading day by taking the total value of all the assets in the fund, subtracting any liabilities, and then dividing that by the number of outstanding shares. As the value of the underlying securities in the mutual fund changes, so too does its NAV, and consequently, the value of your shares.

Returns from mutual funds can come in a few forms. If the securities within the mutual fund generate income, such as dividends from stocks or interest from bonds, this income is passed on to shareholders, usually on a regular basis.

Additionally, if the fund manager sells securities from the portfolio for a profit, these capital gains are distributed to shareholders. Finally, if the overall value of the mutual fund's holdings increases and the manager retains those securities, the fund's share price itself will appreciate, allowing you to sell your shares for a profit at a later date.

Types of Mutual Funds and Examples

Equity Funds

Equity funds primarily invest in stocks. These mutual funds can be further categorized by the size of the companies they invest in (e.g., large-cap, mid-cap, small-cap funds) or their investment style (e.g., growth funds focused on companies with high growth potential, or value funds investing in undervalued companies).

An example of an equity mutual fund might be a fund that tracks the performance of a broad stock market index like the S&P 500.

Bond Funds

Bond funds, also known as fixed income funds, invest in debt securities such as government bonds, corporate bonds, and municipal bonds.

These mutual funds are generally considered less risky than equity funds and aim to provide a steady stream of income. An example could be a U.S. government bond mutual fund.

Money Market Funds

Money market funds are a type of mutual fund that invests in highly liquid, short-term debt instruments, such as Treasury bills and commercial paper.

These mutual funds are generally considered very low risk, offering stability and easy access to your money, though with typically lower returns compared to stock or bond funds.

Balanced Funds

Balanced funds, sometimes called hybrid funds, offer a mix of different asset classes, typically a blend of stocks and bonds. The objective of these mutual funds is to provide both growth potential and income while aiming to mitigate risk through diversification across asset types. A balanced mutual fund might maintain a strategy of investing 60% in stocks and 40% in bonds.

Index Funds

Index funds are a particularly popular type of mutual fund that aims to replicate the performance of a specific market index, rather than trying to outperform it.

Because they are passively managed, their fees are often lower than actively managed mutual funds. A well-known example is an S&P 500 index mutual fund, which holds the stocks of the companies included in the S&P 500 index in similar proportions.

Target Date Funds

Target date funds are designed for investors saving for a specific future goal, such as retirement. These mutual funds automatically adjust their asset allocation over time, becoming more conservative as the target date approaches.

For instance, a 2045 target date mutual fund would start with a higher allocation to stocks and gradually shift towards bonds as 2045 draws nearer.

Updated May 23rd, 2025

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Benefits of Mutual Funds

Investing in mutual funds offers several compelling benefits. First and foremost is professional management. Fund managers are experienced professionals who conduct extensive research and make daily investment decisions for the mutual fund, saving individual investors significant time and effort.

Secondly, mutual funds provide instant diversification. By pooling money from numerous investors, a mutual fund can invest in a wide range of securities across different industries and sectors. This diversification helps to spread risk, as the poor performance of one security may be offset by the better performance of others within the same mutual fund.

Liquidity is another advantage. Most open-ended mutual funds allow investors to redeem their shares on any business day, providing relatively easy access to their money if needed. This daily pricing of mutual funds makes them quite accessible.

Finally, mutual funds can be quite affordable. While some mutual funds have minimum initial investment requirements, these are often much lower than what would be needed to build a similarly diversified portfolio of individual securities.

This affordability, combined with the professional management and diversification, makes mutual funds an excellent choice for many investors.

Considerations When Investing in Mutual Funds

While mutual funds offer many advantages, it is also important to be aware of potential considerations. Fees and expenses are a crucial factor. Mutual funds charge various fees, such as expense ratios, which are annual fees that cover the fund's management and administrative costs.

Some mutual funds may also have sales charges, known as loads, which are commissions paid when you buy or sell shares. Understanding these costs is important because they can impact your overall returns from mutual funds.

Another consideration is that the performance of mutual funds is not guaranteed. Like any investment, mutual funds carry investment risks, and it is possible to lose money, including your original investment. The value of a mutual fund's shares will fluctuate with market conditions.

Final Thoughts

In conclusion, mutual funds serve as a powerful and versatile tool for investors of all experience levels. Their ability to provide professional management, broad diversification, and relative affordability makes them an attractive option for pursuing various financial goals.

By understanding how mutual funds work and exploring the different types available, investors can confidently integrate mutual funds into their investment strategy, building a portfolio that aligns with their personal objectives and risk tolerance.

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By Jordan McCaleb, Investment Researcher