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A mutual fund is nothing more than a collection of stocks and/or bonds. There's nothing magical about them. Most mutual funds are managed by someone who is paid by the shareholders to pick the stocks and/or bonds for them. Mutual funds are comfortable for many people because they don't have to agonize over picking individual stocks or bonds. There are also unmanaged mutual funds such as most index funds. We'll talk about the differences later.
There are disadvantages and advantages to having mutual funds in your portfolio. The biggest advantage is diversification. Buying just one mutual fund gives you an investment in several different companies. The other major advantage is liquidity, your investment can be converted to cash whenever you say so. The biggest disadvantage is buried costs. Learning to read a prospectus will help with this. One of the costs is a managers fee, even though managers pick stocks about as well as a non-professional. Another disadvantage is that you don't have control over the stocks the fund owns.
Types of Funds
Bond Funds - Bonds are basically IOU's issued by companies or governments. The investor is lending money to the company so that they can collect interest, which is usually a set percentage and is paid at regular intervals or on a set date. They are often called 'fixed-income' investments as you know what return you will be getting from them.
Balanced Funds - These funds mix stocks and bonds. Knowing the percentage of each is important in determining the risk level associated with investing in the fund.
General Equity Funds - These are stock funds where the stock represents part ownership in the company. Investors and the companies want to see the value of the stock rise. Stocks are often labeled by the size of their company, so you may see small, medium or large cap funds, based on the companies capitalization.
Index Funds - These funds try to match the returns of a certain index or benchmark. These funds don't try to outperform the market, they try to match it. (The best part of index funds is their low fees - I'm big on index funds but we'll get into that later.)
International Funds - These funds invest in international companies, or a combination of US and international companies, in which case they are categorized as Global Funds.
Sector Funds - These funds invest in one sector of the economy such as computers or Internet.
Fund Fees
The expense ratio is very important, and very easy to find. There are websites such as www.fool.com that list fees of almost any fund you could possibly want, and also look in the fund's prospectus. The expense ratio is made up of the investment advisory or management fee, this is the money that pays the managers huge salary. The management fee will typically be between 0.5 and 1.0 percent annually of the fund's assets. Administrative costs are also included in the expense ratio and are typically 0.1 to 0.4 percent of the funds assets. This pays for the customer service and mailings they send you as well. The 12b-1 distribution fee should be avoided at all costs. This is the fee they charge you to advertise and market the fund. I don't think anyone really cares to see advertisements for a product that they've already bought so you should avoid buying funds that charge you a 12b-1 fee. There is some statistical mumbo jumbo to take all of these fees and determine the expense ratio - I don't know what it is, but you should expect an average of 1.5 for a managed fund and an average of 0.25 for index funds. (See how much money you can save with an index fund?)
Loads are more wonderful fees that are meant to pay for the brokers services. A broker is a middleman that can sell you a mutual fund or share of stock. There are three different kinds of loads. The front-end load is a fee that the broker pays himself for telling you which fund to buy. They typically charge 5 to 8 percent of your investment and take it as soon as you decide to make an investment, thus the name, front-end. The deferred load is even worse. These funds don't charge you a fee until you take your investment out of the fund. Worst of all is the level load. You pay a front-end load and then level loads each year that you continue to hold your investment.
Taxes and Turnover
Lastly you need to look at the tax efficiency of a fund. The turnover rate is important to the tax efficiency. A managed fund that has a high turnover rate will end up distributing the yearly capital gains to you the shareholder. In turn, you will have to pay taxes on the gains.
Reading the Prospectus
The key to choosing a great mutual fund is reading the prospectus so you can find out which of the fees we have discussed are included. The purpose of the prospectus is to tell you the objectives of the fund, what their plan is, what risk is involved, and the fees that are associated with the fund.
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