Investing 101: What Is a Mutual Fund?

Many people want to make money investing so they turn to mutual funds, hoping to capitalize on the long-term growth of the stock market. But before you start investing, it's important to know how a mutual fund works.

A Mutual Understanding. A mutual fund is a collection of assets held by multiple investors for the purpose of investing. The fund most often consists of a mixture of stocks, bonds, cash, and other securities, and is managed by a professional. Buying into a mutual fund is a simple way for people interested in investing to develop a diverse portfolio that is carefully watched over and tended to by a fund manager.

%VIRTUAL-WSSCourseInline-1049% Having a professional handle the investments offers a level of security to the average investor, which is one reason that mutual funds are so popular. Between making purchases and trading decisions and keeping a diversified and well-balanced portfolio, getting involved in the stock market can be difficult for small-time investors. Because mutual funds receive contributions from multiple people, the fund allows investors to own more of the market with a smaller amount of money than they could on their own.

How Does It Work? When investors contribute money to the fund –- or when they buy shares –- they then own a stake in all the investments made by the mutual fund. If 10 people contribute $1,000 each to the same mutual fund, then the net asset value, or NAV, is $1,000, but the total value of the fund is $10,000.

That total amount is then invested by the fund manager into a variety of holdings. This gives the individual investors the power to own a wide variety of stocks, bonds and other securities. When the amount held in the mutual fund is used to purchase something in the market, the investors who own shares in the fund are, by extension, invested in those same holdings. Being invested in such a wide array of stocks and bonds wouldn't be possible for the average investor without the help of a mutual fund.

The entirety of the mutual fund's extensive portfolio is referred to as assets under management. %VIRTUAL-article-sponsoredlinks%The fund manager is compensated for his efforts, which hopefully includes growing the value of the fund, through what's known as the assets under management fee, or the expense ratio. An average expense ratio for a managed mutual fund is around 1 to 1.5 percent.

When a manager successfully grows a fund, the value of the portfolio increases along with the net average value, or NAV. The way NAV is calculated is by dividing the total value of all the securities the fund holds by the number of shares in the fund. Using the example above, if a mutual fund started with a total value of $10,000 and its fund manager then increased the overall value of the fund to $15,000, the original 10 shares in the fund would now be worth $1,500.

Closed-End Funds vs. Open-End Funds. Not all funds are continually open to new investors. Closed-end funds are mutual funds that don't accept new investors. Anyone interested in holding a share in a closed-end fund would have to buy one from a current investor. The value of the shares is determined by the NAV. Most mutual funds, however, are open-end funds, which do allow new investors to bring contributions straight into the fund.

How Do You Make Money With a Mutual Fund? Mutual funds can fluctuate in value, so don't be surprised if you experience some volatility. You can make money from mutual funds in three ways: dividends, capital gains, and growth of the securities within the fund. Often times, mutual funds pay monthly dividends, which you can choose to reinvest back into the mutual fund.

Active Investments vs. Passive Investments. Mutual funds that are professionally managed by a fund manager are referred to as actively managed funds because there's a specific person hired to make the investment choices according the investment objectives stated in the prospectus. On the other hand, index funds are considered passive investments because they don't have a fund manager. Instead, they're a basket of stocks bundled together in the form of a mutual fund, which is designed to mirror an index, such as the S&P 500 (^GPSC). Since these funds don't have a mutual fund manager making trades, they typically have much lower expense ratios (around 0.5 percent).