Mutual funds are actively managed investment vehicles that generally begin life as a lump sum of cash that has been contributed by a group of investors. This cash is then turned into a share certificate, which is then used by a mutual fund manager to purchase investments that he or she thinks will generate a profit.
In most cases, a mutual fund will have a management team rather than an individual controlling the decisions around what investments to make, but this isn’t a requirement. In some cases, the management team will be successful in their investments and create a profit and sometimes not. This is the risk that is represented by mutual funds.
In a traditional mutual fund investment, shareholders get a distribution every time the fund actually makes a profit above and beyond what it costs to manage it. This distribution is known as a dividend. Shareholders that receive dividends are required to pay capital gains taxes on those distributions in the same year they receive them.
What sets mutual funds apart from traditional investment vehicles like stocks and bonds is that they are not traded on any exchange, like the NYSE or Nasdaq. This means that shareholders generally don’t pay a brokerage fee to buy or sell mutual funds. But that doesn’t mean that there aren’t fees associated with being a shareholder. Shareholders are required to pay the management fees associated with the management of the fund assuming the fund isn’t creating the profit necessary to cover these costs. In most cases, these administrative fees are more than a typical broker commission.