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How Do Mutual Funds Work?

Written by Marc Guberti

Marc Guberti is a Certified Personal Finance Counselor who has been a finance freelance writer
for five years. He has covered personal finance, investing, banking, credit cards, business
financing, and other topics.
Marc’s work has appeared in US News & World Report, USA Today, Investor Place, and other
publications. He graduated from Fordham University with a finance degree and resides in
Scarsdale, New York.
When he’s not writing, Marc enjoys spending time with the family and watching movies with
them (mostly from the 1930s and 40s). Marc is an avid runner who aims to run over 100
marathons in his lifetime.

Updated June 7, 2023​

4 min. read​

how do mutual funds work

Investors buy various assets to generate long-term returns, including mutual funds. These funds give you exposure to several assets and streamline diversification. Some investors do no research and trust the mutual funds to provide sufficient returns. This decision gives investors additional time to earn more money, spend time with family, and pursue hobbies. Naturally, not every mutual fund performs as expected. Knowing how mutual funds work gives you the right expectations. It then becomes easier to assess the pros and cons of these funds.

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What are Mutual Funds and How Do They Work?

Investors often hear about the benefits of a diversified portfolio. These portfolios spread your money across various assets, mitigating your risk in the process. If one of your stocks crashes, you have other stocks and assets to cushion the blow. You can use some of your proceeds to buy crypto and other high-risk investments. Investors with crypto can balance this risk with bonds and other low-risk assets. Your portfolio allocations depend on your risk tolerance and perspective on each asset.

Mutual funds invest into a pool of assets with stated objectives and risk-reward levels. These funds reward investors in several ways.

1. Dividend Payments

Some mutual funds distribute dividends to their shareholders. You can use these dividends to cover expenses or reinvest them into the mutual fund. Reinvesting dividends will increase next quarter’s payment. In addition, some mutual funds increase the dividend payment each year to reward long-term investors.

2. Capital Gains

Funds may generate capital gains from selling stocks, crypto, and other assets throughout the year and distribute those proceeds to shareholders. You will owe taxes on these capital gains. Active funds have more trading activity which can result in higher capital gains. Passive funds do little to no trading and focus on long-term investments.

3. Net Asset Value

Net asset value is the total value of the assets within the mutual fund. As asset values rise, so will the mutual fund. Your mutual fund may appreciate it as you hold onto it and generate capital gains. These gains represent the return on your investment. Capital gains are unrealized until you sell shares of the mutual fund. You can hold onto your mutual fund assets to defer tax payments. If you pass your mutual funds to your heir, the cost basis readjusts and protects them from paying taxes on your capital gains.

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How Do You Earn from Mutual Funds?

Investors make money from mutual funds through distributions and price appreciation. Some investors accumulate high-yielding mutual funds to retire sooner. The cash flow can eventually cover living expenses.

You can also make money by selling your mutual funds at a profit. Holding onto mutual fund shares for over a year before selling will reduce your taxes. You’ll only pay at the long-term capital gains tax rate, which is more favorable than the short-term capital gains tax rate.

What is the difference between an Active vs. Passive Mutual Fund?

Active and passive mutual funds aim to provide a profitable return on your investment. Investing professionals manage active mutual funds and decide where the money goes. These fund managers will analyze companies and act quicker on market news than a passive mutual fund.

Passive mutual funds don’t have professionals looking at the money. Instead, these mutual funds mirror index funds or sectors. Index funds and ETFs are two of the most popular passive mutual funds.

What are the Types of Mutual Funds?

Investors can choose from several mutual funds. You can buy several mutual funds to further diversify your holdings instead of relying on a single mutual fund. You can pick from the following options.

Stock Funds

Stock funds are popular mutual funds that let you mimic stock market returns. You can buy index funds that follow the S&P 500 or NASDAQ, or you can get an actively managed fund that can beat the market. In addition, you can select from growth mutual funds to high-yielding mutual funds.

Bond Funds

Bond funds won’t increase as much as stocks, but they offer more reliable cash flow. Investors load up on bonds and similar assets as they get older and want cash flow for retirement.

Balanced Funds

A balanced mutual fund is a hybrid solution for investors who want to buy stocks and bonds. These funds are invested in both of those assets. You should review a balanced fund’s allocation to see if it means more heavily into stocks or bonds. You can also buy some stock mutual funds and bond mutual funds for a similar portfolio.

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Money Market Funds

Money market funds are relatively safe investments that pool resources into cash and cash equivalents. The investments are short-term, which provides minimal upside but greater safety. Money market funds provide more attractive returns than the interest rate you’ll get at the bank, but these mutual funds trail stock and bond funds.

Target-date Funds

Younger investors invest differently from people approaching retirement. Younger investors can take more risks and pour most of their money into assets. Older investors want to accumulate liquid cash and value cash flow. Target-date funds anticipate your changing needs as an investor. These assets’ holdings change as you get closer to the target date, the day you’ll need the money for retirement. Investors can find target-date funds that match their time horizons and let the professionals handle their money.

What are the Pros and Cons of Mutual Funds?

Mutual funds have been around for almost 100 years. These assets have held strong since the MFS’ Massachusetts Investors Trust’s (MITTX) launch in 1924. Mutual funds have gone through some changes and variations since MITTX’s launch. It’s good to know the strengths and weaknesses of any investment before allocating capital towards it. Investors should consider the pros and cons of mutual funds.


  • Automatic diversification: Investing in many assets mitigates risk instead of putting all of your eggs in one basket. Since mutual funds invest in a pool of assets, you already have a diverse portfolio.
  • You save time: Mutual fund holders don’t have to research hidden gems in the stock market. They can invest in mutual funds that do the work for you.
  • Liquidity: You can quickly get in and out of a mutual fund. You can sell shares to cover an emergency expense or if you want to trim your holdings. Other assets such as real estate do not offer that level of liquidity.
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  • Fees: Mutual funds have fees. You should review each fund’s fees before investing. These funds streamline your investments and can provide significant returns. High-performing funds make the fees easier to justify.
  • Less control: You can’t buy and sell investments for the mutual fund. This dynamic limits your control, but mutual funds make up for it with their liquidity. If you don’t like mutual funds anymore, you can quickly exit the position.

Get Started Diversifying Your Portfolio

Mutual funds give you exposure to many assets and can save significant time. Making monthly contributions can accelerate your path to wealth and give you more options in retirement.

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