Mutual funds are the best way to invest your money with minimal risk and good returns. When choosing what to invest either through your retirement savings plan or an individual investment account — we recommend sticking with a well-diversified mix of mutual funds.

What is a mutual fund?

When you invest in a mutual fund, you are using your money to purchase stocks, bonds and other kinds of securities. With a mutual fund, you don’t have to invest in the individual securities, which can be very complicated. Instead, a mutual fund manager takes your money and combines it with other investors’ money to buy a diverse mix of investments.

• See also: Stocks, Bonds

You can find mutual funds that invest in virtually any type of security. The types of investments the fund manager buys depend on the fund’s objectives and approach — which are described in detail in a long disclosure document called a prospectus. There are more than 10,000 mutual funds available in the United States, which means there are more mutual funds than there are stocks for those mutual funds to invest in. You can learn more about different kinds of mutual funds at:

• Morningstar: www.morningstar.com

There are more mutual funds available in the United States than there are stocks for those mutual funds to invest in.

While it may seem overwhelming at first, learning some basic things about mutual funds will give you the knowledge you need to pick the one that is right for you.

Why invest in mutual funds?

There are several advantages to investing in mutual funds. When you buy into a mutual fund, you are able to invest in dozens or often hundreds of stocks and bonds — which makes your money diversified. The more investments you have, the less you have to worry about losing money if one investment loses value. Owning such a broad mix by purchasing individual company stocks would be impossible on your own unless you had a very large amount of money to invest.

Mutual funds also require very little work on your part. The fund managers follow the fund’s investment approach and style, invest new money that comes in and make sure cash is available when investors cash out their shares. Many funds are able to do this at very low cost to you — as low as $7 per year, for every $10,000 invested. The exact cost varies a great deal from fund to fund, so it’s a good idea to research the costs of mutual funds and stick with those that have low costs.

Another benefit of mutual funds is that you can turn some or all of your fund shares to cash by selling them at any time. Also, mutual funds also have to regularly file documents describing their holdings and financial condition with the Securities and Exchange Commission (SEC), a part of the federal government that oversees securities. This regulation reduces the risk of fraud and makes mutual funds a safer option for individual investors than investments with no regulatory oversight.

• SEC: www.sec.gov

How does a mutual fund work?

Most mutual funds are open-ended. That means that they can constantly accept new cash from investors and buy additional investments with that cash. Investors can sell their mutual fund shares at any time and receive the value of those shares in cash.

When you buy a mutual fund, you usually have to make a minimum first investment of anywhere from $500 - $3,000. After that, you can make additional purchases as often as you would like. Usually there are minimum purchase amounts, but they’re usually smaller than the first-time minimum.

When you make your purchase, you become a shareholder of the mutual fund. The fund manager — usually one person or a few people — then takes your money alongside the other shareholders’ money and buys and sells investments to successfully grow the fund.

When you go to buy a mutual fund, you may see a term called Net Asset Value (NAV) — the NAV determines the mutual fund price. The NAV is set once a day at the end of the day and refers to the total value of the investments that the fund is holding at that time, divided by the number of shares that exist. Most mutual fund trades occur only at the end of the day and you buy or sell at the NAV price. If the current NAV is $15 and you invest $1,000, you’ll buy 100 shares. Keep in mind that the number of shares you’ll get or the NAV has no significance when comparing different mutual funds — it’s just a way of keeping track of how much you own.

What are the most common types of mutual funds?

Mutual funds are an extremely popular way to invest and there are literally thousands of different funds to choose from. Fortunately, it can be relatively simple to trim down the list of candidates once you narrow down the type you’re looking for.

There are three things to look at when trying to understand different mutual funds:

• What investment types the mutual fund owns — stocks, bonds and other securities
• How the fund managers pick the investments
• How you buy the mutual fund

What the mutual fund invests in

You can find a mutual fund that invests in any category of stocks or bonds, as well as hybrids like asset allocation mutual funds and balanced mutual funds that combine the two. Balanced mutual funds tend to own a mix of stocks and bonds — such as, 60% stocks and 40% bonds — or a mix of one type of investment based on a certain category, like geography — such as 60% U.S. bonds and 40% international bonds. Asset allocation funds change their mix based on market conditions.

Hybrid funds exist so you can own a diverse mix of stocks and bonds without having to own multiple mutual funds. If you have a retirement plan, you’ve probably come across a target date fund. This is a type of hybrid mutual fund that is intended for investors who plan to begin withdrawing cash to spend beginning on a known date — often 20 or more years in the future. As that target date gradually approaches, the investment mix shifts from stocks to more conservative bonds, to reduce the amount of risk for the investor.

In addition to stock, bond and hybrid mutual funds, there also are money-market mutual funds, which are very low-risk and perform similarly to savings accounts.

How you choose to invest in mutual funds depends on your investment goals and style. In general, your goal should be to own a mix of mutual funds that invest in a diverse range of stocks, bonds and other securities.

How the mutual fund is managed

There are two basic mutual fund management types: passively managed and actively managed. If you choose to buy a passively managed fund, also commonly known as an index fund, you also have the option of buying an Exchange-Traded Fund (ETF).

• Actively managed mutual funds

When a mutual fund is actively managed, the fund manager studies individual companies, the economy, business trends and other factors to determine which investments to buy or sell. Active management requires a lot of analysis — which requires a great deal of skill and time, as well as money to pay for analysts. Actively managed funds usually trade investments frequently, which can mean they cost more for investors.

• Passively managed (index) mutual funds

When a mutual fund is passively managed, the fund’s board of directors sets an investment strategy and hires a fund manager to execute that strategy. The fund manager sets a certain investment criteria based on the fund objectives and buys investments to match that criteria. Usually, the criteria are a single asset class like “Short-term Corporate Bonds” or “Large U.S. Value Stocks.” This kind of fund assumes that it’s impossible to gauge the performance of individual investments within the asset class, so they focus instead on matching the average performance of all of them.

Passive management usually is set up to mirror the investments included in a stock market index like the Standard & Poor (S&P) 500 or the Russell 2000. For this reason, passively managed mutual funds are often called index funds even though some of them do not track a specific market index.

• Exchange-traded funds

An ETF is a type of mutual fund that is organized a bit differently than the open-ended funds discussed so far. You buy ETFs through a brokerage account. Instead of picking a fund from among that brokerage firm’s mutual fund offerings, you can buy any ETF — they trade like individual stocks.

• See also: Stocks

You can buy or sell ETFs any time the stock market is open, rather than just buying or selling at the end-of-day NAV (like with traditional mutual funds). ETFs can cost less than traditional mutual funds because they are usually passively managed. Their sponsors also don’t have to deal with all the hassles associated with the typical mutual fund — sending account statements, having an 800 number where investors can call and ask questions and other regulatory requirements. There are some tax-related differences between an ETF and mutual fund, too (you can find that in the ETF prospectus).

If you plan to own ETFs for a long time, their cost savings can add up. However, when you buy and sell ETFs, you pay a commission — and even small commissions add up.

Most of the differences between ETFs and traditional mutual funds are somewhat technical in nature, and having to do with the way shares are created and exchanged with investors. Most ETFs are some type of index fund. Dozens of ETFs exist — many in unusual categories and obscure indices — so it’s important to be very careful when choosing one.

How to choose between actively managed and passively managed funds:

Once you’ve decided on a mutual fund to buy, your next decision is how you want the managers to select your investments. This is when you choose between and actively or passively managed fund approach.

It may seem that active management would be the better approach since it is more hands on and has more in-depth analysis. Over the long term, however, few active managers actually end up outperforming comparable passively managed funds and most investors will do better with the passive approach.

There are three main reasons why:

• Actively managed funds cost more.
  Passively managed funds cost less to run and so cost investors less in the long run. The higher costs of active management — which can be an additional 1.5% per year or more — are just a higher hurdle to get past before you’re “winning” as compared to the passive approach.

• Actively managed funds are unpredictable.
  No one has ever found a consistently reliable method for evaluating actively managed mutual funds. While it’s easy to pick actively managed funds that have done well in the past, it’s impossible to predict the future. Many past winners have fallen to the bottom of the list after a few good years. With active stock mutual funds you take on not just the risk of investing in stocks, but also the risk of picking an inferior manager.

• When diversified correctly, actively managed funds start to act like passively managed funds.
  Actively managed funds legally have to own dozens or hundreds of stocks to call themselves “well diversified.” So their investment mix starts to mirror a market index — behaving similarly to lower-cost passively managed funds.

When choosing investments, we recommend that you focus on picking the investment types that meet your needs — stocks, bonds and other securities — and buying passively managed mutual funds that own those types. This will simplify your investment process and should lead to better results than more complicated alternatives.

How to buy the mutual fund

Mutual funds tend to fall into two fee categories, based on whether or not the investor pays a sales commission. These are called load funds and no-load funds.

• Load funds

Load funds are mutual funds where you pay a sales commission, usually either at the time of purchase or at the time of sale. If you do purchase load funds, you’ll often have three share classes to choose from. Which share class to buy depends on how long you expect to own the fund. Your sales representative can walk you through the comparison.

• Class A
  With Class A shares, you pay a commission up front (a front-end load) often starting at 5% or 5.75% with lower rates for larger amounts invested. You also have to pay an annual expense.

• Class B
  Class B shares do not have a commission at purchase. Instead, they have a Contingent Deferred Sales Charge (CDSC), which is a commission you pay if you sell your shares. The sooner you sell your shares, the higher the commission rate. The commission rate starts to decline in the years after your purchase. Class B shares also usually have higher annual expenses than Class A shares. With Class B Shares, after the CDSC period runs out — usually in seven to eight years — the shares convert to Class A shares.

• Class C
  With Class C or level load shares, you pay a 1% commission each year. That commission never goes away.

In addition to those classes, load funds also may have a fee called a 12(b)(1) fee, which pays for the company’s fund marketing expenses. All these loads and fees are on top of the expenses paid to fund managers for managing the investments.

• No-load funds

No-load funds — which brokerage firms also sometimes call No Transaction Fee (NTF) funds — do not charge sales commissions. When purchasing a no-load fund, you can buy them directly from a mutual fund company, like The Vanguard Group or T. Rowe Price, or you can purchase them through an online or discount brokerage, like E*Trade, Fidelity or Charles Schwab, which sometimes adds on a small “ticket charge” to process a trade.

The mutual fund company doesn’t charge this fee if you buy their fund directly through them. However, you don’t have to go through the mutual fund company to buy a no-load fund — and even if you have to pay a ticket charge, it will be less than the commission paid on a load fund

How to choose between load funds and no-load funds:

No-load funds are a better option because they reduce your investment costs. There’s no proven method of picking winning mutual funds, so paying a sales representative to make your picks doesn’t really guarantee more investment success.

No-load funds are a better option because they reduce your investment costs.

The only time you would want to pay a sales commission is if you want a specific fund or strategy that is only available in a load fund or if you want hands-on help picking investments. In general, load funds only make sense if you are getting valuable advice from the representative selling them to you. Otherwise, they are usually much more costly to own than no-load funds — and that’s less money in your pocket.

What are the other costs of mutual funds?

In addition to the sales commissions required by load funds, there are other fees you may come across when researching mutual funds:

Expense ratio

A mutual fund’s expense ratio is the cost of owning the fund per year, stated as a percentage of the total amount invested. Most of this cost goes to paying the fund’s managers, but can include other things if the fund is a load fund.

Most index funds have expense ratios under 0.30%. They can be as low as 0.05% - 0.10%. Foreign stock index funds are typically higher. Actively managed funds can have expenses as high as 2.50% per year or more. On average, mutual fund expenses are a bit more than 1% annually, though it varies a great deal by fund and share class.

Some investors own mutual funds overseen by a fee-only investment advisor. That adds a layer of fees on top of the mutual fund expenses. The cost depends on the specific advisor and must be disclosed to you in a document called a Form ADV. As with load mutual funds, this additional cost only makes sense if you receive valuable services in exchange for paying it, or it allows you to purchase funds (such as “institutional class” funds) you want but otherwise cannot access.

Hidden costs

Mutual funds can have hidden trading costs that aren’t included in those expense ratios. Look at the turnover rate listed for a fund to see how often it buys and sells investments. If the turnover is 100%, that means that, on average, every holding is replaced once each year.

You also may have to pay tax costs — this depends on how much the fund pays out each year in distributions and where your account is held.

Where can I buy mutual funds and exchange-traded funds?

Most people first learn about and pick stock mutual funds and ETFs as part of the process of opening and funding a retirement plan at work or an Individual Retirement Arrangement (IRA). Your retirement plan at work typically limits your purchases to a short list of funds, and has specific paperwork for opening an account and selecting investments.

Other than with these types of retirement plans, we recommend that you purchase mutual funds directly from the companies that manage them or from online or discount brokers.

When picking a mutual fund or exchange-traded fund provider, we do not recommend a full-service broker, which can cost you more in fees. Instead, we recommend you work with a mutual fund company, online brokerage or discount brokerage, which will keep your fees low. And while we don't recommend a specific provider, the following sites can help you research different options:

• The Wall Street Journal’s (WSJ) Smart Money: www.smartmoney.com 
• The Motley Fool: All About IRAs: www.fool.com/money/allaboutiras/allaboutiras.htm
• CNN Money 101: money.cnn.com/magazines/moneymag/money101/lesson13/index.htm

There are many other online and discount brokerages also available, so make sure to research the one that works best for you — to see what funds are available and what the costs are.

If you purchase ETFs, you’ll need to open a brokerage account because ETFs are traded the same way as stocks. If you don’t need advice, any online or discount brokerage account will do. Offerings are similar, though costs can vary a bit from one to the other. Check the current commission rates to see which is most competitive for whatever you plan to buy.

Many banks, credit unions and savings and loans institutions also have brokers available to customers who want to buy or sell mutual funds. The costs can be higher than discount brokers, but that isn’t always the case and you may receive some advice in exchange for those higher costs.

Words to know

Unsure about something you read? Many of the financial terms you came across in this article are defined in our financial glossary. A-Z Glossary

Links we like

Here are a couple online features you might find useful:

• Investopedia Mutual Fund Tutorial:
  www.investopedia.com/university/mutualfunds/#axzz1W9sUsjcf
• Morningstar Mutual Funds: www.morningstar.com/Cover/Funds.aspx
• SEC: What Is a Mutual Fund: www.sec.gov/answers/mutfund.htm
• The Motely Fool Mutual Fund Center: www.fool.com/mutualfunds/mutualfunds.htm