What is a Mutual Fund?

A mutual fund is a professionally managed fund that lets you pool your money with other investors to purchase a collection of securities—such as stocks and bonds—across multiple corporations or other issuers (government, investment trusts). Although investors don't directly own the securities, they mutually share in the fund's profit or losses.

Investors in mutual funds get several significant benefits:

Since mutual funds are invested in numerous companies and other issuers, they can help offer immediate diversification. 

Mutual funds are easy to buy and sell as they provide one-stop shopping. If you wanted to invest in all the stocks in a mutual fund that owns 100 companies, for example, you could do it the hard and costly way by buying an equal proportion of all 100 companies, or you could buy them all in one place through a mutual fund.

Having a professional manager reviewing and researching the mutual fund's portfolio on an ongoing basis takes a lot of the work—and emotions—out of investing. Fund managers have disciplined processes for buying and selling, which can help investors navigate challenging periods in the market, when they might have otherwise let fear or uncertainty negatively affect their investing decisions.

Because you don't directly own the underlying securities, you don't have control over the mutual fund's sales and purchases.

If you choose to invest through a mutual fund, you pay the mutual fund manager a fee, usually expressed as an "operating expense ratio," or OER. How much you pay largely depends on which of two main types of mutual funds you're investing in, active or passive.

The first of the two main types of mutual funds are index funds—otherwise known as passively managed funds. With an index mutual fund, the fund manager aims to match the market's performance. For example, an index mutual fund modeled after the Standard & Poor's 500^® index consists of all the companies in the index in the same proportion. In this way, the index mutual fund seeks to track the performance of the S&P 500^® index as closely as possible. When the index adds or subtracts from its holdings, the index fund manager follows suit. That's why index funds fall under the category of "passive management." Because index funds require less managerial insight, they are generally less expensive.

Actively managed mutual funds, on the other hand, require more decisions on the part of the fund managers. Rather than matching the market, they try to outperform it. That means the fund manager needs to decide not only which securities to buy and sell and when, but also in what proportion to other holdings in the mutual fund. Active managers typically try to buy low and sell high, which can generate taxable gains (profits earned on a sale) that need to be managed as well. Because of these extra responsibilities, actively managed mutual funds typically charge more than index funds.

Despite their differences, index funds and actively managed mutual funds are really two sides of the same investing coin, and many investors use both types in their portfolios.