What Is a Mutual Fund?

A mutual fund is a type of professionally managed investment that pools investors' money to buy certain assets like stocks or bonds. These assets are bought with the intention of growing investors' wealth through ownership of specific interest bearing instruments and capital gains from equity investments. The set of decisions made about asset purchases are together called an "asset management strategy".

In the United States, a fund must earn a specific classification. In order to become one officially, its managers must register with the Securities and Exchange Commission. Within the category, there are a few different types of mutual fund to choose from. The first, which is simply called a mutual fund, generally undergoes active asset management from those who run it. They use these asset management strategies to try and maximize the return on investment for investors. The other type, generally called an index fund by financial professionals, uses a more passive investment strategy. In short, an index fund shuns active asset management strategies, preferring instead to put investor's money in a portfolio representative of an entire index, like the S&P 500.

Costs and Fees
As previously mentioned, a mutual fund that uses an active asset management strategy makes money for its investors through interest and capital gains. A mutual fund is often classified by its own particular asset management goals, as some are riskier (and have potentially higher gains) than others. Generally speaking, high-growth asset management strategies involve many transactions and higher equity exposure. Less risky asset management strategies, meanwhile, typically involve fewer transactions and have lower equity exposure.

An index fund grows in close correlation with the index that it is invested in. If the S&P 500 grows 5 percent in one year, for example, a given index fund that tracks the S&P 500 should have a return of about 5 percent for that year. Historically, the average index fund has outperformed the average actively managed mutual fund in terms of return. But this precedent is far from certain, as an index fund is very susceptible to its index of choice's volatility and losses.

In the current environment, the most common place where a typical investor will purchase a mutual fund is in a retirement account like a 401(k) or an IRA. Many 401(k) accounts allow participants to select between various mutual fund options. Because tax consequences are not a primary concern in a retirement account, the different treatment that an index fund gets should not matter. At this point, the primary concern in selecting a fund should be the strategy and the expense ratio. The advantages of an index fund are that they will have low expense ratios and will not rely on the skill of a particular individual to achieve returns. If the underlying market goes up, as most tend to do over the long-term, the investor in an index fund will get a pure return with low costs.