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What's a mutual fund and how do you invest in one?

July 27, 2023
5 min read

What we'll cover

What a mutual fund is
Different types of funds
How they work in a portfolio

Much like a trip to the supermarket, when you invest in mutual funds, you put your money into a variety of securities that work together to help you pursue your investment goals. So, what are mutual funds, and how do they work in a portfolio?

What are mutual funds?

A mutual fund pools money from numerous investors and invests it into different securities. Think of it as a basket holding different types of investment assets.

A mutual fund can invest in such things as:

Individual stocks
Bonds
Real estate
Precious metals
Commodities, such as oil or wheat
Other mutual funds (called a fund of funds)

Learn more: Invest in mutual funds commission-free (on eligible U.S. securities) with Ally Invest

How do mutual funds work?

Mutual funds allow you to diversify your holdings, and they also give you the benefit of professional management. When you buy shares of a mutual fund through a brokerage, you become a shareholder in that fund and own a portion of each of the securities included in the fund.

A fund manager decides which securities to buy and sell inside the fund based on its investment objective. They also oversee the fund's trading activities and use their expertise and knowledge to guide their decision-making.

Read more: Mutual funds vs. ETFs

So how do mutual funds work? Besides mutual funds increasing or decreasing in value based on their underlying investments, you can earn returns in a few different ways:

Dividends
Capital gains: Earned by selling your shares of a mutual fund for more than what you paid, or when a fund manager sells securities within the mutual fund for more than its initial purchase price. Read about the tax implications .

How mutual funds are managed

Let's look at the two ways mutual funds are managed:

Actively managed funds are designed to try to “beat” the market, hopefully delivering above-average returns to fund investors
Passively managed funds are designed to "meet" the market by mirroring the performance of a specific benchmark

Mutual fund expenses and fees

Mutual funds can charge ongoing fees and transaction fees. Ongoing fees are the different charges included in the fund's expense ratio (a.k.a. the annual cost of owning the fund). For instance, management fees, 12b-1 fees and operational fees. All fees are listed in the fund’s prospectus for you to peruse.

As a general rule, index funds and other passively managed mutual funds tend to have less expensive expense ratios than actively managed funds, but it's always important to compare them side by side to see how the costs add up.

Transaction fees include expenses like trading fees, fund share redemption fees and sales charges (a.k.a. loads). When it comes to these fees, mutual funds can be categorized by having:

Front-end sales load: Commission or sales charges when purchasing the mutual fund shares based on a percentage of the sales price
Deferred or back-end sales load: Flat fee or gradually decreasing fee you might pay when selling mutual fund shares
No-load funds: A no-load fund does not mean "no fees." Besides underlying fund expenses, a no-load fund can charge various transaction fees.

At Ally Invest, there are no transaction fees on mutual funds, but individual funds can have fees within them, so it’s important to account for the charges and expenses of any mutual fund you’re considering. This information can be found in the fund’s prospectus, which you can obtain by emailing support@invest.ally.com.

Investing in mutual funds

To start investing in mutual funds, you'll need to open an online investment account, which you can do with Ally Invest. Then, choose your fund with the following considerations:

Asset classes included (i.e. stocks, bonds, etc.)
Active or passive management
Fund performance and fund manager’s track record
Recurring and one-time fees

Finally, think about how a fund matches your objectives, risk tolerance and time horizon to see how it’ll fit into your portfolio's asset allocation.

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