What is a mutual fund, and how does it work?

If you’re thinking about investing in a mutual fund, also known as an open-ended fund, there’s much to consider beforehand. 

We explore everything you need to know, including what a mutual fund is, how it works and the pros and cons.

What is a mutual fund? 

A mutual fund is a type of investment fund. Your money is pooled together with other investors, offering you exposure to various investments, diversification and the opportunity to spread risk.  

An investment manager manages the fund and uses their expertise and experience to invest in many assets, including bonds and stocks, in the hopes of generating high returns and dividends.  

You can choose to have your dividends paid out to you or reinvest them to acquire more shares.  

To find out the value of a mutual fund, you look at the net asset value (NAV), which is the total value of assets in the fund minus any debt, which is then divided by the number of shares. 

Similar to other funds, there’s usually a minimum amount you have to invest, which can vary.  

How does a mutual fund work? 

A fund manager will use a mutual fund to invest in many assets; how they choose these assets will depend on their financial goals and risk appetite.  

When you invest in a mutual fund, you’re buying shares in it. The funds are traded once daily after the stock markets close, so there are fewer price fluctuations. 

As mutual funds are open-ended, the assets are split into units. If more people buy instead of sell, more units are issued. So, it works differently than investment trusts, which are closed-ended funds.  

What are the different types of mutual funds? 

There are many types of mutual funds, including:  

• Equity funds: These invest solely in stocks, with the criteria being set in many different ways. If you own a share of a company, you’ll potentially get paid dividends.
• Index funds: These are usually passive (so no fund manager is involved) as they replicate a market index.
• Fixed income funds: These focus on assets such as bonds that offer a fixed rate of interest.
• Money market funds: These are typically lower risk with lower returns than other funds as they invest in higher liquid, short-term debt.  

You can also invest in balanced funds that focus on different asset classes with low and medium risk, income funds and global funds that invest in assets outside your country. 

There are a few ways to make money when investing in a mutual fund. You could get paid dividends, or capital gains could be passed on if the share price rises for an asset and the fund manager sells it for a profit. 

As mutual funds cannot borrow money to invest in more assets, known as gearing, they are arguably less risky than investment trusts, which can do this. 

While gearing can boost the value of your investments, it can make losses worse if share prices fall.  

A mutual fund manager must distribute any profits each year. However, if there are challenging years, any payments could be lower than expected.  

If you want more predictable income, an investment trust might be worth considering, as up to 15% of net income can be retained annually for future payments if the stock markets are challenging.  

What are the pros and cons of mutual funds? 

As with any investment, there are many benefits and risks to consider before buying a mutual fund.  

There are several pros to investing in a mutual fund, including: 

• Having an experienced fund manager handling the investments and strategy to try and generate the best returns possible.
• The chance to earn dividends and possibly reinvest them, which may supercharge your investment thanks to compounding.
• A more diversified and lower-risk option than other investments, such as individual stocks.
• Less price fluctuations as mutual funds are traded once a day. 

However, there are some disadvantages to consider, including: 

• Potentially higher fees than other investments, as mutual funds can be expensive to manage.
• No control over investment decisions made by the manager.
• Less likelihood of receiving predictable dividend payments. Mutual funds must distribute profits yearly and cannot retain up to 15% of net income like investment trusts.  

Do I pay tax on mutual funds? 

You usually pay tax on any gains or income unless you hold a mutual fund in an individual savings account (ISA) or self-invested personal pension (SIPP).  

So, if you don’t use an ISA or SIPP and use your allowances, you may have to pay tax on dividends and profits, as well as capital gains tax, if you sell your shares for a profit.  

How do I buy and sell mutual funds?  

There are many ways to buy and sell a mutual fund, either directly from the fund provider or through an investment platform. 

A financial adviser may be able to offer guidance on the best fund for you and buy one on your behalf. Unbiased can connect you to an FCA-regulated adviser, and your first consultation is free.  

Should I invest in a mutual fund? 

Whether or not a mutual fund is right for you depends on your circumstances, long-term money goals and risk appetite. 

It’s worth remembering the value of your investments can rise and fall. 

It’s a good idea to talk to a financial adviser before investing, as they can help with your long-term strategy and help you mitigate any risks.