Mutual funds: What they are, how they work and how to invest in them

Chances are, when you go to the supermarket, you don't fill your cart up with just one item. Instead, you buy vegetables, pasta, cheese, fresh bread, maybe a nice bottle of wine — all the various ingredients you need to create a delicious meal. 

It's similar to investing in mutual funds. You put your money into lots of different things that work together to help you pursue your investment goals. But you’re not making dinner, you’re developing a recipe for attempting to build wealth. So, what are mutual funds and how do they work?  

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. When you buy shares of a mutual fund, you purchase everything inside the basket. 

Mutual funds can even hold other mutual funds. (This is called a fund of funds.)

It can be time consuming and costly to trade hundreds or even thousands of securities on your own, but mutual funds allow you to diversify your holdings (which is one way to manage risk) and benefit from professional management. When you buy shares of a mutual fund through a brokerage like  Ally Invest , you become a shareholder in that fund, owning a portion of each of the securities included in the fund. 

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

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

The first: dividends. A dividend represents a share of a company's profits. If a mutual fund holds individual stocks that pay dividends, it collects these payments and distributes them to its investors.  (Fixed-income funds pays interest on bonds, which is described below.) A mutual fund's prospectus will tell you if it pays dividends. (A prospectus is a document that essentially breaks down how the fund invests, its past performance, risks, and what you'll pay to own it.) 

The other way to make money investing in mutual funds is through capital gains. A capital gain occurs when a fund manager sells a security held inside the fund for more than its initial purchase price. You can also realize a capital gain by selling your shares of a mutual fund for more than what you paid. 

How do capital gains affect your taxes? Read about the tax implications of trading .

Mutual funds make portfolio diversification easier since you can pick and choose which mutual funds to buy based on your risk tolerance and financial goals. 

Let's start with how mutual funds determine their investment strategy. First, you have actively managed funds. With these, the fund manager has one goal: to try to “beat” the market, hopefully delivering above-average returns to fund investors. 

Passively managed funds, on the other hand, have a different investment strategy. Their goal is to "meet" the market by mirroring the performance of a specific benchmark. 

Mutual funds can be further broken down by what they invest in. Each type can offer a different risk/reward profile, depending on what it invests in. Broadly speaking, you can choose between:

Equity (or stock) mutual funds invest mainly in stocks. They can be actively or passively managed and carry a higher level of risk than some other types of mutual funds.  There are different types of stock funds, so see Growth funds and Value funds below. 

Passively managed index funds try to mimic the performance of a market index, like the Nasdaq 100 or the S&P 500 and are usually comprised of many or all of the stocks that make up the index.   

Usually referred to as bond mutual funds, they invest in fixed income debt securities, such as government or corporate bonds (that’s debt issued by businesses). Fixed-income funds are typically less risky than other types of investments and most provide interest income earned from the debt instruments held. 

Investing in lower-risk, shorter-term debt like U.S. Treasurys, municipal bonds, corporate or bank securities, and cash, these funds are typically resistant to market volatility. 

This type of mutual fund invests in a mix of stocks and bonds.

Income funds sometimes referred to as income and growth funds, often invest in stocks that pay dividends. Because of this, they are generally considered less risky than mutual funds that are focused on growth or capital appreciation. 

International funds generally hold securities of companies outside of the U.S. These funds offer a way to diversify your portfolio, but they can carry greater risk due to unique risks of investing internationally versus domestically. 

Target date funds often invest in a combination of stocks, bonds, and other investments.  Another way to invest for retirement, these mutual funds are designed with their asset allocation aligned with your preferred retirement date. They're easy to recognize since they typically have a year (i.e. 2045, 2050, etc.) in their fund name. 

Growth funds tend to focus on companies that have the potential for above-average growth and do not typically pay dividends. 

These funds invest in companies that have been undervalued by the market.

As you learn more about mutual funds, you’ll likely find that, on the surface, some of their features look similar to other types of investments. But dig a little deeper, and you’ll begin to see what makes mutual funds unique. 

Mutual funds and exchange-traded funds or ETFs sound similar — they’re both basket-like investments that allow you to diversify your portfolio by investing in hundreds or thousands of securities. Plus, they both can pay dividends. The main difference in a nutshell: An exchange-traded fund trades throughout the day on an exchange just like a stock. 

Normally, when you buy or sell one or more mutual fund shares, the trade is only executed once per day — after the market closes — at the fund's daily net asset value (NAV). With an ETF, trades can be executed throughout the trading day or even during after-hours trading if you're using an online brokerage that allows it. That means you don't have to wait for NAV to be calculated. Instead, you can take advantage of whatever price an ETF is trading for at that particular moment. 

The main difference between a  mutual fund vs. index fund is that index funds invest in many or all securities found on a specific market index. For example, an index fund may invest in the stocks found on the S&P 500. Mutual funds may invest in a variety of stocks, regardless of what index they are benchmarked against. As we mentioned, index funds are typically passively managed and attempts to mirror their benchmark's performance. An investor might lean toward index funds over actively managed mutual funds if they want lower fees and expenses. 

When you buy shares of a stock, you invest in a single company. In contrast, when you purchase shares of a mutual fund, you’re investing in hundreds or thousands of companies at one time. If you recall, that’s because a mutual fund can be thought of as a basket holding a variety of securities. 

Mutual funds can charge ongoing fees and transaction fees. All of these charges will be listed in the fund's prospectus. 

The expense ratio is expressed as a percentage of fund assets. For example, a mutual fund might have an expense ratio of 0.50% or 0.75%. Different mutual funds can have different expense ratios, depending on whether they're actively or passively managed and what they invest in. Some may be significantly more expensive than others. 

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. 

Finally, think about how a fund matches up with your goals, risk tolerance and time horizon to see how it’ll fit into your portfolio's asset allocation. Now, you’re ready to go forth and discover how mutual funds can be part of a recipe for attempting to build wealth.