Mutual Funds

What Are Mutual Funds?

Mutual funds are a basket of investment securities, where the investor’s money is pooled together and diversified into stocks, bonds, and other assets. The combination of these assets forms a portfolio, where an experienced fund manager chooses what assets should be bought and even sold. Mutual funds are often sold on the market and bought through brokerage firms like Vanguard or Fidelity.

How Do They Work?

The job of the fund manager is to obtain exposure to a variety of assets with the investor money, where they have full control over your investment in order to follow or beat the benchmark index. In turn, the brokerage firm gets money through various fees placed on the investor; it’s also how the firm distributes fund manager salary.

Their share value is calculated by finding their Net Asset Value (NAV). The formula is:

Total Value of Fund Assets - Fund Expenses

NAV =

Number of Shares Outstanding

The fund manager will follow strict rules and pattern expectations on what type of assets they should buy in the portfolio. Some will match the portfolio, while others will attempt to beat the benchmark index. How do they know what to choose? Well there are two classifications of Mutual Funds: Active and Passive. Depending on which you bought, the fund manager will behave a certain way.

Active vs Passive Mutual Funds

• Their main objective is to outperform a benchmark index. They cost more and are riskier than their passive counterparts. This is because a professional fund manager has to buy and sell assets based on their predictions and expectations of the market.

• High Turnover: Simply meaning they are held for a shorter period of time because the fund manager is constantly buying and selling assets to maximize its profits/capital gains.

Active Mutual Funds

Earning Money

So the important question is, how do we make money? There are a lot of ways Mutual Funds can make you money, so let’s take a look at the chart below and discuss what each earning type means:

1. Dividend Payments: Both classes of Mutual Funds may earn dividend payments. When companies distribute dividends on stocks or interest on bonds, the fund manager will distribute that money to all the fund shareholders.

2. Capital Gains from Selling Fund Shares: When an investor sells their mutual fund shares at a profit.

3. Capital Gains Distribution: When the fund manager sells assets at a gain, the fund realizes a capital gain, which is distributed to shareholders. All investors in the fund will have to report this distribution for taxes even if they didn’t sell their fund shares.

PRos and Cons of Mutual Funds

PROS

1. Diversification

   • Since a mutual fund contains a bunch of different companies’ stocks and bonds, the risk is distributed out, ensuring your chances of losing money to be uncommon. It doesn’t fully eliminate it, but is better than an individual stock.

2. Automatic Reinvestment

   • Typically brokerage firms will offer dividend reinvestment; whenever you make money from the fund, you can automatically purchase more shares of that fund. Automating this makes it more passive and is a quality of life setting.

3. Low Pricing

   • The barrier to entry is low, as it’s typically bought by the dollar amount, rather than share amount. Although some brokerage firms may have a minimum amount in order to buy a fund, there are plenty of other firms that have low or no minimums.

4. Portfolio Manager

   • By paying a small fee, you can have a professional fund manager to direct your assets to make you money. You don’t have to have a lot of knowledge in your assets, but you’re paying someone to do it for you.

1. Fluctuating Expense Ratios

   • This is less of a problem for Passive Mutual Funds, as they have mostly low and stable expense ratios (they can still change). On the other hand, Active Funds will fluctuate in expense ratios because of changing operating costs. This matters because it can decrease the amount you gain from the asset funds.

2. Tax Inefficiency

   • Discussed earlier, when the fund manager has to sell an underlying asset at a profit, every shareholder must recognize this capital gain distribution when filing taxes. If the majority of investors try to sell their fund shares, the fund manager may have to sell underlying assets to meet the demands. So even if you’re selling at a loss, you may still have to recognize a capital gain.

3. Bad Availability and Liquidity

   • Mutual Funds are bought and sold at the end of the day, based on their closing NAV. You can’t maximize profits yourself, nor are you able to obtain your money until the market closes. This poses a big problem if you urgently need the money.

Concluding Thoughts

You now have a firm grasp on the basics of understanding what Mutual Funds are and what makes them attractive to many investors. However, there is an agreement that Mutual Funds are best taken advantaged in a Tax-Advantaged Account, as one of the biggest cons of this investment class is the Capital Gains Distribution and the Liquidity.

Remember that this isn’t investment advice, but just a way to inform you on the types of investments that are out there. Please do more research on Mutual Funds before you invest and ask professionals if you have questions. If you’re wondering how they compare to ETFs, you can check it out in my other blog, Understanding the Basics of ETFs, where I discuss the benefits and disadvantages of both of them.

Sources:

Palmer, B. (October 15, 2025). Pros and Cons of Mutual Funds: Key Benefits and Drawbacks. Investopedia. https://www.investopedia.com/ask/answers/10/mutual-funds-advantages-disadvantages.asp

(Retrieved March 9, 2026). Understanding Mutual Funds. CharlesSchwab. https://www.schwab.com/mutual-funds/understand-mutual-funds

(Retrieved March 10, 2026). Active and passive fund management: What's the difference?. Thrivent. https://www.thriventfunds.com/insights/mutual-fund-focus/active-passive-fund-management-whats-the-difference.html

(Retrieved March 11, 2026). Mutual Funds. InvestorGov. https://www.investor.gov/introduction-investing/investing-basics/investment-products/mutual-funds-and-exchange-traded-funds-etfs/mutual-funds