How Does a Mutual Fund Work?

How Does a Mutual Fund Work?

What a Mutual Fund is

An investment company opens up a fund called a mutual fund and then encourages shareholders to invest in the mutual fund. The mutual fund generally has a theme, such as "Index 500 Companies" or "Long-Term Insured Municipal Bonds." The investment company uses the invested money to buy shares in a wide variety of financial investments that match the theme of the mutual fund. While an investor in a mutual fund might only own one share of a mutual fund, the mutual fund itself owns multiple shares of multiple investments.

Level of Risk

All mutual funds come with some level of risk because the government does not insure them. While past performance is generally a good indicator of future performance, nobody can guarantee that a particular mutual fund will provide a certain level of return on the investment. The investment company generally assigns a level of risk to each mutual fund, such as low risk or high risk, so that investors can make informed decisions about which mutual fund to choose.

Role of the Mutual Fund Manager

Each mutual fund has a mutual fund manager who is responsible for overseeing the growth of the mutual fund. The mutual fund manager, as well as a team of financial analysts, researches the area of investment and makes informed decisions about which stocks or bonds to buy or sell in order for the mutual fund to achieve the highest rate of return.

Load Versus No-Load Mutual Funds

Some mutual funds charge an initial investment fee, which is called a "load." For example, if a mutual fund has a load of 1 percent, then when you invest $1,000 in the fund, you will only see $990 in your mutual fund account. Other mutual funds charge no initial investment fees, so an initial investment of $1,000 would place all $1,000 into the mutual fund. This type of mutual fund is called a "no-load" mutual fund.

Mutual Fund Shares

When you invest in a mutual fund, you own a certain number of shares of that fund. Just as with stock prices, the price of a share of a mutual fund fluctuates. So, you might find that the value of the shares that you hold in the mutual fund are higher one day and lower the next. If you choose to sell your shares in a mutual fund, you will be responsible for paying taxes on an increase in the value of the shares. If you lose money, then you may take a deduction for the loss.

Passing Along Profits and Losses to Mutual Fund Owners

Throughout the year, the mutual fund manager will buy and sell stocks, bonds or other investments with the mutual fund's money. Periodically, the profits and losses from these decisions are passed along to the owners of the mutual fund. The investment company reports this income to the federal government, and you will have to pay taxes on the profits, even if you reinvested the profits into the mutual fund.