Mutual funds enable hundreds, and in some cases even millions, of investors to pool their money together in order to make investments. Investors in mutual funds entrust their investment decisions to a professional money manager and his/her staff. Most mutual funds have clearly defined investment practices and objectives for their investments. With nearly 10,000 different funds now available, there is most likely a fund that will cater to just about any investment objective you might have.

Mutual funds can be broken down into two basic categories: equity and bond funds. Equity funds invest primarily in common stocks, while bond funds invest mainly in various debt instruments. Within each of these sectors, investors have a myriad of choices to consider, including: international or domestic, active or indexed, and value or growth, just to name a few. We will cover these topics shortly. First, however, we’re going to focus our attention on the �nuts and bolts� of how mutual funds operate.

The first thing to be aware of are the various fees associated with any given mutual fund. There are three major fees to look for:

Management Fees — It costs money to hire a group of professional money managers. However, you should be very mindful of the management fees charged by any fund you’re considering making an investment in, as some fund’s fees can be downright exorbitant. The typical fee charged by most equity funds averages somewhere in the neighborhood of 1-1 �% per year. Meanwhile, most bond funds charge about half that amount.

Front or Back-end Loads — These are fees that fund companies charge investors when they purchase or sell a fund. You can pay a maximum 8.5% fee upfront (called a front-end load) or when you sell (called a back-end load). It’s important to note that these fees are in addition to any trading commissions and yearly management fees you may be charged. In general, we look for �no-load� funds—those that do not charge fees for purchases or sales.

12(b)-1 fee — Funds are allowed to charge a maximum of 1% per year to cover �sales and marketing� costs. This fee can include some items that most investors would consider questionable, so be on the lookout for funds that have a high 12(b)-1 charge.

When looking at different funds, you’ll also notice a term called NAV, which stands for Net Asset Value. This is the price that it will cost to purchase a share of the fund. It is determined by the amount of assets under management divided by the number of shares outstanding. If a fund has $1 million under management and has 100,000 shares outstanding, then its NAV would be $10 ($1,000,000 / 100,000 = $10).

Another important item to note is that each mutual fund share represents an equal percentage of the fund’s overall value. However, most funds hold a variety of different stocks/bonds, and these holdings are almost never weighted equally as a percentage of the fund’s assets. For instance, assume the fund above consists of only three holdings; $500,000 of GE, $300,000 of IBM, and $200,000 of Cisco. (In reality, of course, most mutual funds usually invest in a diversified basket of 30 to several hundred different holdings.) The total value of this fund is equal to $1 million, while each share of the fund is equal to $10. Each share, however, consists of 50% GE ($1M / $500,000), 30% IBM, and 20% Cisco Systems. So, by purchasing one share of this particular mutual fund for $10, you’re essentially gaining an interest in $5 of GE, $3 of IBM and $2 of Cisco Systems. This is the primary benefit of mutual funds—they enable investors to gain exposure to a basket of stocks with one single transaction.

Why are Mutual Funds so Popular?

Mutual funds provide an easy way for small investors to make long-term, diversified, professionally managed investments at a reasonable cost. If an investor only has a small amount of money with which to invest, then he/she will most likely not be able to afford a professional money manager, a diversified basket of stocks, or have access to low trading fees. With a mutual fund, however, a large group of investors can pool their resources together and make these benefits available to the entire group. There are no �perks� for the largest investor and no penalties to the smallest—all mutual fund holders pay the same fees and receive the same benefits.

Mutual funds are also popular because they provide an excellent way for anyone to direct a portion of their income towards a particular investment objective. Whether you’re looking for a broad-based fund or a narrow industry-focused niche fund, you’re almost certain to find a fund that meets your needs. Although the various style and category types are virtually endless, here’s a quick summary of some of the various choices available to equity investors:

Broad-Based Funds — Investors can use mutual funds to gain exposure to the broad U.S. stock market. A number of funds track such well-known indices as the S&P 500 and Dow Jones Industrials, as well as even broader indices like the Wilshire 5000.

Market Cap Oriented Funds — Some funds invest exclusively in stocks of a particular size, such as large-caps (generally defined as companies with market caps of at least $10 billion), mid-caps ($1-$10 billion), small-caps ($300 million to $1 billion) or micro-caps ($50-$300 million).

Investment Style/Objective Funds — Some funds invest primarily in value-oriented stocks. Meanwhile, others are much more aggressive, investing exclusively in growth companies. Still others invest in income-oriented issues. The different investment styles and objectives to choose from are virtually endless.

Industry/Sector/Niche Funds — Certain funds specialize in one particular industry. For example, some funds invest in Biotech stocks, while others invest only in gold & silver companies, etc. Meanwhile, other funds focus exclusively on niche markets, such as companies that are going through mergers or IPOs (initial public offerings).

Country/Region Specific Funds — Investors can use mutual funds to gain exposure to equities based in a particular country (Brazil, China, etc) or region (Europe, North America, etc), as well as broad exposure to stocks all over the world.

Actively Managed vs. Index Funds — Some funds are actively managed by professional money managers. Meanwhile, others are passively-managed funds that track a particular index or hold a fixed basket of stocks.

Another advantage of mutual funds is that they usually make it very easy to invest small sums of money on a regular basis. In fact, many funds allow investors to make automatic deductions right from their bank accounts or paychecks.

And finally, another reason for the popularity of mutual funds is that many investors simply cannot afford to properly diversify and manage their portfolio throughout the year. To achieve the best results from diversification, a portfolio needs to contain at least 30 holdings. Instead of going out and purchasing 30 different stocks and managing them all year, an investor can just buy shares in a mutual fund and let the manager take care of all of the day-to-day decisions.

What are some drawbacks to Mutual Funds?

As mentioned above, fees can be a serious impediment to mutual funds. In fact, some of the costliest funds may charge 4-5% per year in fees. Any fund that charges high fees will undoubtedly claim that it does so in an effort to provide superior management. While this may occasionally be true, it is rarely the case. Studies have shown that in the long run, most mutual funds underperform the overall market by exactly the same amount they charge in fees. With this in mind, we suggest finding funds with low expense ratios and no front- or back-end loads. A fund that charges 2% per year will cost you $200 for every $10,000 that you have invested. Unless the fund can outperform the market by 2%, you will have unwisely paid the manager extra money when you could have put that same money into your own portfolio. Index funds generally provide the overall lowest costs because they do not actively manage their holdings (this lowers managerial and transaction costs). These are often referred to as �passively-managed� funds because they simply track a predetermined index such as the S&P 500, Dow Jones Industrials, or the Nasdaq Composite.

Where Can I Learn More?

Below you’ll find a host of additional resources that you should find useful in the course of your mutual fund research:

Morningstar — From the undisputed leader in mutual fund information, this site serves up descriptions, return analysis and proprietary ratings on over 2,000 different funds.

Yahoo Mutual Fund Center — Features current fund news, fund screeners, return calculators and an invaluable educational section.

Sector Updates Mutual Fund Center — This site includes a plethora of links to mutual fund screening tools, fund company contact information, educational materials and current mutual fund news.

Fidelity — Fidelity is one of the world’s largest fund managers. You’ll find plenty of information here on both 401(k) plans and individual mutual funds.

Vanguard — This firm has made its reputation as the low-cost fund leader. Before investing in index funds, every investor should learn more about Vanguard�s founder, John Bogle, and his philosophy on mutual funds.

Mutual Fund Education Alliance — This is a good all-around mutual fund investment site that covers many different topics.

IndexFunds.com — This quality educational site clearly demonstrates that the risk/reward ratio favors investing in index funds.