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A fund is a pool of money that is managed by a professional. The professional is responsible for finding investments that suit the funds objective. The profits from the investments are shared among those who have contributed to the pool of money. The professional fund manager is then compensated with a share of the money for his/her time & efforts.

The advantages of funds are:

1. Individuals don't have to worry about the various intricacies of investing. The finer details and executions are handled by the fund managers, while you can focus on the broad level direction of your portfolio.
2. They are quite efficient. For instance, if you want to have diverse range of investments you will pay a lot in trading fees for buying and selling each thing. The fund manager however can do this in wholesale and get cheaper rates.

Read more about: Collective investment scheme

Mutual Funds

One of the most popular type of funds are mutual funds. They typically invest in stocks that the fund manager thinks as appropriate for the risk level of the fund.

Some of the biggest problem with mutual funds are:

1. Mutual funds require a dedicate manager who can get pretty expensive. These managers get upwards of $200,000/year as salary. In general, a mutual fund charges 1-2% of your investment as yearly fee. Thus, if your investment makes 9%, you might get only 7% after the fee. This 2% difference can be huge. If you are investing $1000 for your retirement, the fund goes to $13000 with 9% return and just $7000 at 7% return.
2. Given its inefficiency, many mutual funds require a minimum of $10000 investment, thus pricing out many investors.
3. With mutual funds, you can trade in the middle of the day.

Evolution of ETFs

By 1980s, finance researchers found that many of these dedicate fund managers perform no better than a fun that blindly picks all the major stocks in a market. Technology also enable people to automate many of the processes. Thus, in 1993 began a new invention.

With ETFs, the fund managers don't have much of a job. What they do is, they pick a certain group of stocks (called an index — this will be a topic on its own). The biggest advantage of an index is that you no longer need to pick a winner in a market. For instance, if you split your money between Apple, Google and Microsoft stocks, you will likely win, no matter which company wins the tech battle for PC & Mobile.

Let us start with an example:

Suppose you want to start with a fund that focuses on cloud computing. What I will do is pick a list of companies related to cloud computing. Let me pick some 10 stocks and assign them almost equal weights. That means for every $100 in the fund, I will invest $3 in Rackspack stocks, $3 in Akamai and so on.

1. Rackspace Hosting, Inc. ( RAX ): 3.31%
2. F5 Networks, Inc. ( FFIV ): 3.29%
3. Brightcove Inc ( BCOV ): 3.29%
4. TIBCO Software, Inc. ( TIBX ): 3.28%
5. Red Hat, Inc. ( RHT ): 3.23%
6. Akamai Technologies, Inc. ( AKAM ): 3.22%
7. NetSuite, Inc. ( N ): 3.20%
8. Oracle Corporation ( ORCL ): 3.20%
9. Teradata Corporation ( TDC ): 3.19%
10. Equinix, Inc. ( EQIX ): 3.18%

Then you setup an automated trading process, where as soon as someone puts money in your fund, your software goes and automatically buys these stocks in that ratio. Now, you can buy and sell in that fund, all day long without worrying about the fund managers salaries. (The example above is taken from a real ETF named SKYY).

Now, you can start getting creative. How about starting a gold ETF? In this etf, instead of buying stocks, we will buy gold bars. Thus, as soon as someone puts $1000 in the fund, we will place an order for $1000 worth of gold bars and store it a vault. The same can be done for almost any asset.

Summary:

1. Funds help investors manage their investments without getting lost in the details.
2. ETFs are a type of funds that almost does away with a professional fund manager and replaces it with an automated technology.
3. ETFs are extremely efficient given the low overheads.

Feel free to shoot more questions on ETFs and I will answer them for free.