Retirement, Investments, & Insurance for Individuals Build your knowledge What are mutual funds and how do they work?

What are mutual funds and how do they work?

Curious about how mutual funds work and how they may fit into your financial strategy? Here are the basics.

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3 min read |

When you have retirement savings like an individual retirement account or a 401(k) account, you can choose how to allocate the money you’re investing. One investment option for those accounts may be mutual funds. What are mutual funds and how do they work? Here are some insights.

What is a mutual fund?

A mutual fund is simply a pooled investment, registered with the Securities and Exchange Commission. Each mutual fund has a stated goal, or objective, such as “income”; that goal helps determine the investments that make up the mutual fund. Mutual funds differ from individual stocks in a couple of key ways.

When you own an individual stock of a company, you have voting rights on key initiatives of that company. The more stock you own, the more votes you get. By owning that individual stock, you are also subject to the company’s variability in earnings, losses, and dividends.

Mutual fund owners, on the other hand, purchase a share of the fund—not just one company—which is invested in a lot of different things. Unlike stock ownership, mutual fund ownership doesn’t have any voting rights.

What are the types of mutual funds?

Active funds

Active mutual funds employ a professional manager to constantly choose and adjust the mix of investments based on the objective of the fund and try to beat the fund’s index. Funds can include the following asset class categories:

Balanced A mix of stocks and bonds invested to maintain a specific balance or exposure
Bond/fixed income A fixed (and typically minimal) rate of return from interest income and the purchase of undervalued bonds
International/global Invested in companies or bonds outside of the U.S./a combination of investments both in and outside the U.S.
Sector/specialty Invested in a specific industry or market
Short term/fixed income Often low risk, invested in securities that have a very short-term duration, high-quality debt, or cash equivalents
Target date fund/Asset allocation Investment risk adjusted over fund lifecycle (based on a particular target date)
Target risk Invested for a target level of risk—e.g., conservative, moderate, aggressive
U.S. equity/stock Invested in the stocks of companies

Passive funds

A passive mutual fund creates an investment mix that tries to be in line with an existing index—think, the S&P 500, for example. Because passive funds try to replicate a market index, they are often referred to as just that—an index fund.

How do mutual funds make money?

Mutual funds can reward shareholders in three primary ways.

  1. The fund receives income in the form of dividends and interest from the shares of stock or bonds that it owns which is paid out in scheduled dividends.
  2. The price of securities that a fund owns appreciates, generating capital gains paid out at least once a year.
  3. The shares you sell generate a higher net asset value (see below) than when you bought them because of an increased price in securities generating a profit/capital gain.

What are common mutual fund terms to understand?

Some key terms to help you understand mutual funds:

  • Fees and expenses: These typically include both an annual fee and fund management costs. Each investment charges an expense and the total return is net of these fees.
  • Minimum investment: The minimum dollar amount required for investment in a mutual fund.
  • Net asset value (NAV): The value of one share of the mutual fund, calculated by the fund manager at the end of each trading day and used to determine the price of mutual fund shares to new investors.
    • Formula: NAV = (market value of all shares - fund's liabilities) ÷ number of issued shares
  • Portfolio manager: The person or head of a team of people tasked with managing mutual funds in the best interests of the shareholders.
  • Prospectus: The statement of mutual fund objectives that determines the investment’s portfolio mix. Every investor must receive a copy of or access to the prospectus as a prospective buyer, investor, or participant.
  • Total return: Measured in one-, five-, and 10-year or since inception periods, this is the positive or negative change in the value of a fund over time.

What's next?

What’s included in your retirement savings? Log in to your Principal account to check out the mix of investments. Don’t have an employer-sponsored retirement account? We can help you set up your own retirement savings.