What is a mutual fund?

How shares are priced and how investors make or lose money

Mutual fund shares are generally bought and redeemed at the next calculated net asset value, or NAV, minus any applicable redemption fee, rather than at a price that fluctuates throughout the trading day the way a stock's price does, according to Investor.gov. Investors can make money from a mutual fund in three ways: dividend or interest payments the fund distributes, capital-gains distributions when the fund sells securities at a profit, and an increase in the fund's NAV itself; funds generally let shareholders choose to receive these payouts in cash or reinvest them in more shares, per Investor.gov. Capital-gains distributions can create a tax liability for a shareholder even in a year when the fund's overall value has fallen, and the SEC's guidance on fund performance notes that a fund's portfolio turnover affects both trading costs and how much taxable gain gets passed through to investors each year.

Risk: mutual funds are not insured or guaranteed

Mutual funds are not insured or guaranteed by the federal government, and an investor can lose some or all of the money invested, according to Investor.gov. The FDIC does not insure securities or mutual funds even when they are offered through a bank, and the SIPC, which can step in when a brokerage firm fails, protects against a firm's failure and does not protect against ordinary investment losses, per the same Investor.gov page on risk. Past performance of a fund does not predict its future returns, though it can show how volatile the fund has historically been, and funds that pursue higher potential returns generally carry higher risk, according to Investor.gov.

Fees and expenses

Every mutual fund deducts fees and expenses from its assets before calculating NAV, so investors pay these costs indirectly even when no fee appears on a statement, and small differences in cost can meaningfully affect long-term returns, according to Investor.gov. A fund's prospectus contains a standardized fee table listing annual operating expenses — management fees, distribution or service fees known as 12b-1 fees, and other expenses that together make up the expense ratio — as well as shareholder fees such as sales loads, redemption fees, exchange fees, and account fees, per the SEC's Investor Bulletin on mutual fund and ETF fees. A front-end sales load is deducted when shares are purchased — a 5 percent load on a $10,000 investment leaves only $9,500 actually invested — while a back-end or contingent deferred load is charged on redemption and may decline the longer shares are held, according to the same SEC bulletin. A "no-load" fund means it charges no sales load, not that it charges no fees at all, and funds that hold other funds may also pass along acquired fund fees and expenses, the bulletin notes. The SEC illustrates the cumulative effect of costs: a hypothetical $10,000 investment earning 10 percent annually before expenses grows to roughly $60,858 after 20 years at a 0.5 percent annual expense ratio, but only to about $49,725 at a 1.5 percent expense ratio.

Regulation and disclosure

Mutual funds are registered with the SEC and regulated under the Investment Company Act of 1940, which imposes safeguards including limits on illiquid holdings, restrictions on borrowing and debt, and a requirement that funds stand ready to redeem shares on any business day, according to Investor.gov's description of alternative mutual funds, which draws the contrast with hedge funds that are not subject to the same rules. Before buying shares, a fund must provide a prospectus describing its investment objectives, strategies, risks, fees, and past performance, and these documents can be searched on the SEC's EDGAR mutual fund prospectus database. The SEC also publishes structured data extracted from the risk and return summary sections of these prospectuses for comparison across funds, available through its mutual fund prospectus risk/return summary data sets.

Common types of mutual funds

Mutual funds are typically categorized by what they hold and how they're managed. Money market funds invest in liquid, short-term debt and cash equivalents, generally carry lower risk and historically lower returns than other fund types, and fall into government, municipal, and prime categories, with most retail and government funds seeking to maintain a stable $1.00 share price, according to Investor.gov. Target date funds hold a mix of stock, bond, and other funds and are designed as long-term vehicles for goals like retirement, typically shifting toward a more conservative mix — generally from more stocks toward more bonds — as the named target year approaches; they're commonly offered, and sometimes used as a default investment, inside 401(k) plans, per Investor.gov. Alternative mutual funds, also called "alt funds" or "liquid alts," hold nontraditional assets such as global real estate, commodities, or start-up equity, or use strategies like short selling and derivatives, and while they remain subject to the Investment Company Act's investor protections, they generally carry higher costs and risks than conventional stock or bond funds, according to Investor.gov. Ultra-short bond funds invest in fixed-income securities with very short maturities and, unlike money market funds, are not subject to the same quality, diversification, and maturity requirements, so their NAV can fluctuate and they are not insured, per Investor.gov.

Before investing

Anyone considering a mutual fund should read its prospectus and most recent shareholder report, compare share classes and fee structures, and check the fund's costs against similar funds using a tool such as FINRA's Fund Analyzer, which the SEC highlights as a resource for comparing fees, expenses, and performance across funds. Prospectuses for specific funds can be located through SEC EDGAR's mutual fund search.