NEW YORK ( TheStreet ) — The concept behind mutual funds is quite simple — easy entry into a liquid, diversified, low-cost, professionally managed investment for the individual investor. However, as with many other good ideas, the best laid plans of mice and men often go awry.

Mutual funds were first developed in Europe in the 1800s. In 1924, the first mutual fund was introduced in the U.S. with the creation of the Massachusetts Investors’ Trust in Boston (now the center of the universe for mutual funds).

In 1928, the spread of publicly available mutual funds began in earnest. In the 1960s and 1970s, mutual funds began to really grow as investors returned to the stock market.

Why? At the time, U.S. commission rates for buying and selling stocks were fixed and thus transaction charges took a big bite out of an individual’s investment performance. The average cost of transacting stocks in mutual funds was significantly cheaper. It also allowed for diversification, which individuals were not able to achieve on their own.

However, the biggest contributor to mutual fund growth was the establishment of the Individual Retirement Account in 1981. That growth has spread over the years to 403(b), 401(k), SEP, Keogh and Roth IRA account plans.

As the financial markets progressed, the benefits of mutual funds have morphed and in some cases have become warped. For years, mutual funds have been incorrectly labeled as the lowest-cost way to invest in the market and provide tax efficiency. However, that’s not true. I call this the Mutual Fund Myth.

To understand why this is so, you need to know the basics of mutual funds first. This lesson will cover many of the mutual fund basics and key terminology. In a future lesson, I will discuss how mutual funds have lost their way, what to avoid when investing in mutual finds and further explain the Mutual Fund Myth.

What Are Mutual Funds?

Mutual funds are pools of assets managed by professional investment advisers for the benefit of shareholders. These funds and the advisers who manage them are regulated under federal law and in particular, The Investment Company Act of 1940 and The Investment Advisors Act of 1940.

Closed-End Funds vs. Open-End Funds

Mutual Funds take one of two structures:

1. Closed-end funds have a fixed amount of shares, just like a public corporation. Shares are typically traded on a stock exchange or market like the Nasdaq. Closed-end funds are transacted based on a market price as determined by a bid/offer auction system. Investors may be subject to a commission charge from their brokers to buy or sell such funds.

2. Open-end funds are funds by which the fund sponsor constantly issues and redeems shares based on demand to buy or sell by investors. Open-end funds are transacted at the net asset value adjusted for other transaction charges (see below).

Important Mutual Fund Terminology

Here is a list of common terms that you will encounter as you navigate the mutual fund landscape:

• Net Asset Value (NAV). This represents the book value per mutual fund share. Put simply, it represents the difference of assets minus liabilities, divided by total shares. Open-end funds are transacted and quoted at NAV (adjusted for fees).
• Premium. A price paid or quoted in excess of NAV for a closed-end fund. The premium is typically expressed in percentage terms of NAV.
• Discount. A price paid or quoted in less than that of NAV for a closed-end fund. The discount is typically expressed in percentage terms of NAV.
• Family of Funds. A fund sponsor that has a multitude of mutual funds available for investors to select from. These funds vary by sector, weighting, asset allocation or asset class. There are many mutual fund families out there. Some of the most recognizable ones are Fidelity Investments. Putnam. Dreyfus. T. Rowe Price (TROW ). Legg Mason (LM ) and Blackrock (BLK ) .
• Load. Sales charges that are paid by open-end mutual fund investors when they buy or sell shares. Loads come in many variations and I have devoted an entire section to mutual fund loads below. These are typically quoted as a percentage of NAV.

• Management Fees. The investment fees paid by the fund to the investment adviser for services rendered in managing the fund. These are typically quoted as a percentage of NAV or gross assets depending upon the fee structure as outlined in the funds prospectus.
• Expense Ratio. Expressed in percentage of NAV, this represents expenses incurred by the fund for legal, accounting, regulatory, custody, and nonadviser expenses.
• 12b-1 Fee. Fees charged by the mutual fund sponsor to the mutual fund for promotion, distribution, marketing and shareholder services. By regulation, 12b-1 fees are capped at 1% and shareholder service fees are capped at 0.25%.
• Fund Manager. The actual individual who is responsible for the day-to-day management of the mutual fund. The two most notable fund managers are Peter Lynch, who managed the Fidelity Magellan Fund (FMAGX ). and Bill Miller, who managed the Legg Mason Value Trust (LMVTX ). LMVTX had a remarkable string of outperformance relative to the S&P 500. ending in 2006.
• Distributions. Mutual funds are required to make annual distributions to shareholders so as to preserve their status as nontaxable pass-through entities. According to regulations, at least 90% of the realized capital gains (long and short-term capital gains are identified separately) and ordinary income (interest and dividends) must be distributed annually. Typically, funds will do so once a year and most often in December, but some funds might opt to do so with more frequency, as is the case for fixed income closed-end funds. The ability of investors to reinvest distributions into more shares of the fund is quite prevalent with open-end funds but cannot be accomplished only through a dividend reinvestment plan or broker program for closed-end funds.
• Exchange Traded Funds (or ETFs). A special form of closed-end fund, ETFs are the most rapidly growing subsector within the mutual fund world. Whereas traditional open-end funds and closed-end funds are actively managed, ETFs are passively managed and seek to replicate or track an index or sector. The most popular ETF is the Spyders (SPY ). which replicates the S&P 500.

Loads and Fees for Open-End Funds

Sales and redemption charges for open-end funds take many forms and are quite confusing. Loads are typically expressed as a percentage of the NAV. The load also will likely be a function of the method of distribution of the fund. If you can buy directly from the sponsor, it is more likely that your loads will be less than if you buy the fund from a broker who distributed the funds for the sponsor. You may seek out so called no-load funds. However, be careful because that name can be deceiving as 12b-1, early redemption or other fees may apply.

Here are the forms of loads or fees that you are likely to be charged for open-end funds:

• Front-End Load. A load or charge that is paid to the sponsor or broker when purchasing the fund.
• Sales, Deferred or Back-End Loads :These charges are paid when selling an open-end fund. A straight-back end load is just deducted from the proceeds upon the sale of the fund. Some back-end loads are a function of the initial investment, which is then applied as a percentage of the sales proceeds. Contingent deferred sales charges (CDSC) will be calculated based upon the holding period of the investor. Furthermore, the CDSC will decline over time as the investor’s holding period increases. For example, the CDSC may be 5% if sold within one year, 4% if sold after one year but before two years have elapsed, 3% if sold after two years but before three years have elapsed and so on.
• Exchange or Switching Fee. A fee paid to move assets from one open-end fund to another within a mutual fund family.
• Short Term Trading Fee: These come under various descriptions and are charged to investors if they fail to hold onto their fund shares for a minimum amount of time. This fee is designed to create a disincentive for short-term trading of mutual funds.
• Low Balance Fee. If your investment in a fund falls below a certain critical level, a fee or recurring charge may be assessed to you.
• Custodial Fees. These are levied for retirement accounts that have special operational and reporting requirements but vary from mutual fund to mutual fund.

How Are the Loads Applied to the Investment or Sale of Open-End Funds?

Buying and selling an open-end fund is not necessarily like buying or selling a stock, so let me provide some examples. Let’s suppose that you plan to invest $10,000 in an open-end fund that has a NAV of $75 and a 1% sales load. You would pay $75.75 per share and receive 132.013 shares. Now suppose a few years later you sell the shares when the NAV is $150.00 and the sales load is 2%. You would receive $19,801.95 (132.013 shares times $150.00), less 2%, or $396.04, for net proceeds of $19,405.91.

If you buy a closed-end fund, you pay the trade price and add a commission. When you sell it, you sell at the trade price and receive the proceeds less a commission.

Selecting Mutual Funds

So now we know we know all about the types of mutual funds and the plethora of fees that they charge. Next, we turn to the fund-selection process, which is actually not much different than shopping for a car. Think of a car’s gas efficiency, i.e. miles per gallon, or mpg, in terms of the cost of running a car. The higher the mpg, the lower the cost.

You can search for similar vehicles in terms of size and features, but you select the more fuel efficient car. Also, the size of the car matters. A bigger car (think large-cap) might not move as fast but is safer than a compact car (think small-cap) that might be faster or more maneuverable, yet is far less safe. Now with that in mind, let’s turn to selecting a mutual fund.

First, you should identify the type of asset class that you want — large-cap, small-cap, domestic, global, bonds, blended, etc. Once you answer that, zero in on funds that meet those investment criteria. You need to know the fund’s performance, how it ranks with its competitors, its risk profile, what stocks it owns and how it rates vs. the competition.

Fund performances will vary, and your selection process should focus on not only one-year, but five-year and 10-year performance records. Check to see how the fund did in both up and down years. Finally, as I will next discuss, take a look at independent mutual fund ratings.

Here is a link to such performance information for the Brandywine Advisors open-end fund (BWAFX ). You will notice a table with the fees and expenses. Also on this page is some information from the independent mutual funds rating company Morningstar. The Morningstar Style Box will categorize the fund based on market capitalization of the typical holding and the asset allocation strategy.

In addition, Morningstar will rate the fund with a star system (one star being low and five starts being the top rating) to help compare funds against others of similar asset category and style. While past performance is not indicative of future results, you should see how the fund has performed. especially in down years.

You should also examine the top 10 holdings of the fund. Why? This will personally help you with diversification. It makes no sense to invest in a fund that already overlaps with other holdings in your brokerage account of other funds.

Finally, for more sophisticated investors, the risk statistics may be of help.

We will pick this topic up at another time, but let’s walk away with a few key points and some homework:

Key Points.

• Mutual funds come in closed-end and open-end structures, each of which have different characteristics.
• Loads and fees are numerous and can potentially be deceptive in the ways in which they are charged.
• No two mutual funds are alike, with each one possessing a unique fee and risk structure.

Homework.

• If you don’t currently own any mutual funds, consider starting a savings plan for investments and seek out a mutual fund with a low initial investment.
• If you are currently invested in mutual funds, ascertain the fee and load structure you are paying. Are there similar funds with a lower cost structure that you can switch to?
• Are any of your mutual funds chronic underperformers? If so, it may be time to shop around.
• Consider this: Can you achieve your investment objective with a lower cost ETF?