What is a mutual fund?

How do mutual funds work?

A mutual fund is a pool of money from multiple investors that fund managers use to invest in stocks, bonds, and other securities. They provide investors with access to a wide mix of assets selected for the fund. When investors purchase a mutual fund, they get part ownership of the fund's underlying assets.

How do mutual funds make money?

Mutual funds make money in 2 ways:

• Income. When an underlying security that the fund invests in pays interest or dividends, the fund is required to distribute those earnings to its shareholders.
• Capital gains. When a fund sells an underlying security at a price higher than what was initially paid, the fund makes a profit. When the fund's total profits exceed its total losses, it realizes a "net capital gain" and is required to distribute those gains to its shareholders.

Then, as an investor, how do you make money?

• When you receive an income or capital gains distribution from the fund.
• When you sell your fund shares for more than what you originally paid for them.

How are mutual funds taxed?

Mutual funds are taxed in 3 main ways:

• Capital gains distributions. Profits from the fund's sales of securities are distributed to shareholders and taxed. Distributions can be taxed as short- or long-term based on how long the fund held the security. 
• Dividends. Distributed dividends are taxed as ordinary income or at a lower qualified dividend rate.
• Capital gains from selling shares. Profits from selling mutual fund shares are taxed as capital gains. The tax rate you pay depends on how long you've owned the shares.

Some mutual funds have tax benefits. For example, mutual funds that invest in municipal bonds provide income that is exempt from federal taxes.

Why invest in mutual funds?

Mutual funds offer many benefits, including:

• Diversification. Mutual funds manage risk by investing in a variety of assets, reducing the impact of poor performance from any single investment.
• Convenience. Mutual funds are easy to buy and sell, making them accessible to a wide range of investors.
• Variety. There are many types of mutual funds, so you can choose the ones that cater to your specific investment goals and risk tolerance.
• Professional management. Fund managers handle the investment decisions, providing expertise and oversight that can help optimize the portfolio's performance.

Mutual funds might not be right for every investor due to higher minimum investment requirements and the lack of intra-day trading, which can limit flexibility and access to real-time market movements.

What's the difference between an index fund and an actively managed fund?

Index mutual funds and ETFs (exchange-traded funds) aim to track the performance of a particular market benchmark—or "index"—as closely as possible. Actively managed funds employ professional management teams who try to outperform their benchmarks and peer-group averages. Because index funds generally trade less frequently, they tend to be more tax-efficient and have lower expense ratios than actively managed funds—which could mean lower costs for you.

Actively managed funds seek to add value to your portfolio by outperforming a market benchmark. They’re typically more expensive than index funds because they generally have higher expense ratios, management fees, and transaction costs. Despite higher costs, investors may choose actively managed funds for their potential to deliver higher returns. Combining these funds with index funds can enhance the diversification of your overall portfolio.

Learn more about the differences between actively managed and index funds

What's the difference between index ETFs and index mutual funds?

Like index mutual funds, index ETFs offer low costs and broad diversification. In addition, index ETFs can also offer greater tax efficiency. Similar to conventional index mutual funds, most ETFs try to track an index, such as the S&P 500, though some ETFs are actively managed and seek outperformance. The main differences are that ETFs provide real-time pricing and a lower minimum initial investment than an index mutual fund. They trade throughout the day, and you can purchase an ETF for the price of one share. You can trade Vanguard ETFs® for as little as $1.

Index mutual funds can be simpler for new investors. Rather than trading throughout the day, mutual funds are typically priced just once at the end of each trading day. They also tend to offer built-in dividend reinvestment and automatic investments and withdrawals based on your preferences.

Learn more about the differences between ETFs and index mutual funds

What's the difference between load and no-load mutual funds?

Load funds charge a sales fee, either when you buy shares or when you sell them. A sales fee that's charged when you buy fund shares is called a front-end load. A sales fee that's charged when you sell them is called a back-end load.

No-load funds—including all Vanguard funds—don't charge a sales fee when you buy or sell shares.¹

Loads have a direct impact on your investments by reducing the amount you ultimately invest or withdraw.

Here's a hypothetical example:

• Initial investment amount: $10,000
• Minus 5% front-end load: $500
• Net investment amount: $9,500

In this situation, your fund's performance would have to make up for a 5% "loss" before it breaks even.

How to choose a mutual fund

When choosing a mutual fund, you should consider several key factors to ensure your investment aligns with your objectives.

Investment goals

Whether you're aiming for long-term capital growth, seeking regular income, or looking to preserve the money you already have, defining your investment goals is essential to selecting a mutual fund. Start with your savings goals to get an idea of how aggressive you want your investments to be based on your risk tolerance and how long you plan to keep your money invested.

For instance, if you're focused on long-term growth, you might opt for funds that invest in stocks, which historically offer higher returns over time, but are more volatile over the short term. Conversely, if you're prioritizing income or the stability of your initial investment, bond or income funds might be more suitable. Aligning your mutual fund selection with your specific goals helps ensure that your investment strategy is tailored to your financial needs and timelines.

Costs and fees

You should carefully consider mutual fund fees and costs because they can significantly erode returns over time.

One key metric is the expense ratio, which represents the annual fee charged by the fund to manage your investment, expressed as a percentage of your total investment. A lower expense ratio means more of your returns stay in your pocket.

To compare mutual fund costs, you can use online tools or review the fund's prospectus or fact sheet for a detailed breakdown of fees. To help maximize potential returns, look for funds with low expense ratios and no sales loads.

Net asset value

Another important factor is the mutual fund's net asset value (NAV), which is essentially the price per share of the mutual fund and what's used to determine the value of your investment.

Mutual fund values can change daily. The NAV of a mutual fund is calculated at the end of each trading day, typically after the U.S. markets close. This calculation reflects the current market value of the fund's underlying assets minus its liabilities, divided by the number of outstanding shares.

Because the prices of the securities held by the fund can fluctuate daily, the NAV will also fluctuate. You should be aware that the value of your mutual fund investment can rise or fall based on these daily changes, and it's important to monitor these changes to understand the performance of your investment.

Independent fund ratings

You might consider independent mutual fund ratings when initially researching and comparing funds, evaluating risk, assessing long-term performance, and reviewing the impact of manager changes. Regularly checking these ratings can also help you stay up to date about any developments that might affect your investment, ensuring you make well-informed decisions.

Mutual fund ratings from independent sources (for example, Morningstar or Barron's) can be a great resource for general information about a fund and a convenient way to compare mutual funds.

But keep in mind that ratings rely heavily on past fund performance. And as we've learned over the last few decades, yesterday's winners can just as quickly become tomorrow's losers. So be cautious not to put more emphasis on those ratings than you would on your answers to these questions:

• Do the objectives of the fund match my investment objectives?
• How might this fund fit into my overall investment portfolio?
• What are the risks, and am I comfortable with them?
• Can I find a similar fund at a lower cost?

You can find answers to these questions and more in each fund's prospectus. So to avoid any surprises, make sure you read it carefully before you invest.

Total return

Total return represents the change in value—up or down—of an investment over a specific period. You use total return to evaluate the overall performance of a mutual fund by considering both the capital gains (or losses) and any income (such as dividends or interest) generated by the fund over a specific period.

Total return provides a more comprehensive picture of a fund's performance compared with just looking at the change in its NAV. By comparing the total returns of different funds, you can make more informed decisions, ensuring you select funds that align with your investment goals and risk tolerance.

In most cases, you'll see total returns for 1-, 5-, and 10-year periods, as well as since the day the fund opened (its "inception date").

Total returns are one factor to consider when choosing a mutual fund, but keep in mind that past performance isn't an indicator of future performance.

See total returns for all Vanguard funds

Why is the return Vanguard reported for my fund different from the return I earned in my account?

Total return figures listed in public settings assume that:

• An investment was made on the first day of the stated period.
• The investment was sold on the last day of the stated period.
• No money was added or subtracted during the stated period.
• All income and capital gains distributions were reinvested.

In real life, your experience was probably a little—or very—different. So your personal return generally won't match the fund's return exactly.

What is "diversification" in investing and how does it help reduce risks in my investments?

Diversification helps lower overall investment risk by spreading your savings across different types of investments. This strategy can benefit you by allowing growth in certain segments to offset potential drops in others. One of the most effective ways to diversify is by investing in mutual funds or ETFs.

While portfolio diversification can never eliminate all the risks involved with investing, it can help lower your overall risk by spreading it around. You can diversify your investment in these 3 ways:

• Across asset classes. Spreading your money among stocks, bonds, and short-term reserves.
• Within asset classes. Investing in all types of stocks (growth and value stocks from small, mid-size, and large companies) and bonds (short-, intermediate-, and long-term bonds from municipalities, government agencies, and corporations). For even more diversification, we suggest you consider investing at least 30% of the bond portion of your portfolio and 40% of the stock portion of your portfolio in international funds.
• Among mutual funds or ETFs. Gaining access to hundreds—sometimes thousands—of securities through an investment in a single fund. Leveraging mutual funds for diversification allows you to create a more resilient and balanced portfolio that’s better equipped to weather market fluctuations.

How risky is it to have most or all of my investments with one company?

While diversification could also include spreading your savings across multiple financial companies, it can be easier to manage your investments when they're all in one place.

So we make sure you can enjoy that convenience at Vanguard—and still have access to a wide variety of investments.

• Choose from more than 185 Vanguard money market, bond, balanced, and stock funds, including international and sector-specific options.
• Access thousands of commission-free ETFs and no-transaction-fee mutual funds from Vanguard and hundreds of other companies, when trading online.²
• Buy and sell thousands of individual stocks, bonds, certificates of deposit (CDs), and options through a Vanguard Brokerage Account.

Build your legacy with low-cost mutual funds

Investing in Vanguard mutual funds offers several key benefits:

• Lower costs. Lower expense ratios may enhance your long-term returns. The average Vanguard mutual fund expense ratio is 84% less than the industry average.³
• Diversification. Invest in a variety of active and index mutual funds, which provide broad diversification across various asset classes and sectors.
• Strong track record. Many Vanguard funds have a history of consistent performance.⁴