Learn what a mutual fund is, how it works, and its fees, taxes, and risks. Explore fund types and compare ETFs versus mutual funds with Vanguard.
What is a mutual fund?
- Mutual funds allow investors to purchase a collection of stocks, bonds, and other securities in a single investment.
- The funds are managed by financial professionals and can be a convenient way to diversify your portfolio.
- There are different types of mutual funds, as well as costs and fees associated with investing in them. Familiarize yourself with the nuances to ensure they’ll meet your investment goals.
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.
Here’s how investing in a mutual fund works:
What is NAV (net asset value)?
A mutual fund’s net asset value (NAV) is essentially the price per share, and it’s the amount used to determine the value of your investment. 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 rise or fall daily, the NAV will also fluctuate.
The NAV is only calculated once per day, typically after the U.S. markets close. When you buy or sell shares of a mutual fund, your trade is executed at the next available NAV.
Mutual fund minimums and account basics
Mutual funds are a type of investment that can be useful for short- and medium-term financial goals due to their flexibility:
- You can invest as much money in as many mutual funds as you like—though some individual funds have investment maximums.
- You can typically sell shares of mutual funds at any time.
However, most mutual funds have minimum investment requirements—which at Vanguard begin at $3,000 for most actively managed and index funds—in addition to fees. And mutual funds held in investment accounts are subject to capital gains taxes on profits as well.
Explore Vanguard’s low-cost mutual funds.
How do mutual funds make money?
Mutual funds make money in 2 ways:
- Income. When an underlying security 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 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 the account type and how long the fund held the security.
- Dividend distributions. 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 the account type and 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’s 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 intraday 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 some 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 (the cost taken out of the fund’s returns before they’re passed on to investors) 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 recurring investments and withdrawals based on your preferences.
Learn more about the differences between ETFs and 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.
Get to know the different types of investments and how to decide which are right for you.
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:
- Time horizon. This is how long you plan to keep your money invested. Thoughtful investment planning evaluates goals based on the amount of time available to achieve them.
- Risk tolerance. This is the amount of market volatility and potential loss you’re willing to accept as an investor. Your risk tolerance can and probably will vary depending on your goals and time horizon.
For instance, if you’re focused on long-term growth, you might opt for funds that invest in stocks, which have historically offered higher returns over time, but are generally 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.
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. It combines both the income the fund generates and any change in price. 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.
Hidden mutual fund fees to avoid
While there are fees when investing in a mutual fund, watch for unnecessary “hidden” charges. In addition to front-end or back-end loads, brokers may charge transaction fees and redemption fees for buying or selling mutual funds. Some also have what are known as 12b-1 fees, which are paid out of the fund’s assets to cover costs such as marketing expenses or commissions for the broker.
Vanguard funds never charge front-end or back-end loads, and very few Vanguard funds charge fees when you buy and sell shares. We provide full transparency on all mutual fund fees and expenses, and you can find that guidance below.
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 portfolio?
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).
- 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 hundreds of 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 portfolio 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