A mutual fund is a term used to describe any one of several registered investment companies (RICs), organized under the Investment Company Act of 1940 and regulated by the Securities Exchange Commission (SEC). Mutual funds are broadly defined as a collective investment security that pools money together from many investors. Mutual funds manage and invest their assets according to the fund’s objectives. In other words, mutual funds are professionally managed stock portfolios that investors buy shares in.

Types of Mutual Funds

Mutual funds all vary according to their particular asset allocations, goals, investment types, fees and structure. Investors utilize mutual funds for their diversity, affordability, professional management, liquidity and flexibility. However, mutual funds vary greatly and are not always the best option for certain types of investors especially considering the high fees charged by some funds.

A board of directors, who are responsible for determining the fund’s investment objectives and selecting a fund manager to invest the fund’s money, oversee mutual funds. The goal of the fund manager is to bring the highest returns for the fund’s investors while adhering to the risk profile and portfolio objectives set forth by the board. Compensation for fund managers is based on total funds under management, so the larger the fund manager is able to grow the fund’s portfolio, the more money he stands to make.

The term mutual fund can appropriately be used to describe any of the three broad classifications of registered investment companies, as defined under the Investment Company Act of 1940, which include both open and closed-end funds as well as unit investment trusts. A specific kind of open-ended fund called an exchange-traded fund (ETF) has recently gained popularity and has characteristics of both open and closed-end funds. Most commonly, the term “mutual fund” is used exclusively to mean open-ended funds.

Open-end Funds

Open-end mutual funds are a type of registered investment company that will always buy back shares of their fund from the original purchasers. Repurchases are made daily, after the stock market closes and are based on the net asset value (NAV) of the fund’s total portfolio, which is computed daily. Most open-end mutual funds trade on the stock exchange and their shares are available for purchase by the public at a price consistent with its NAV at the close of that trading day. Transactions in open-end funds occur at the end of the day through the stock exchange.

Since open-end funds are constantly buying from and selling shares to investors, the fund manager more actively manages an open-end fund’s investment portfolio. This more active role in management is in order to accommodate the fluctuations in the fund’s investment base, due to the open ended nature of the fund. This increased management activity often comes with higher operating fees than other types of funds because of increased transaction costs associated with buying and selling shares of stock. Open-end funds are the most common type of mutual fund.

Closed-end Funds

Closed-end funds, unlike open-end funds, only sell shares to the public once through an initial public offering (IPO). Shares of closed-end funds trade throughout the day on the stock exchange; however, the closed-end fund has no obligation to buy the shares back from its investors. Thus, when an investor wishes to divest itself of its shares in a closed end fund, he or she must find another investor who is willing to purchase those shares from them. This is similar to how shares of stock in a public company are traded on the stock exchange.

Often, the price at which an investor is willing to buy or sell shares in a closed-end fund differs from the funds net asset value (NAV). If the fund is trading at a price higher than the value of its underlying assets, shares in that fund are said to trade at a premium. Conversely, if the shares in a fund are trading at a price lower than the value of its underlying securities, the fund is otherwise said to trade at a discount. Whether shares of a particular fund trade at a premium or a discount depends on various factors such as the fund manager, the fund itself, overall market conditions and liquidity of the fund’s shares.

The least common type of registered investment company is the unit investment trust. Like a closed-end fund, unit investment trusts, only have one initial public offering. Investors owning shares in a unit investment trust can either redeem their shares with the fund or sell them to other investors. Unit investment trusts are not managed, a feature which differs substantially from both open and closed-end funds. Accordingly, a unit investment trust’s portfolio allocation maintains its original composition and the trust often only exists for a limited duration, as determined at the fund’s inception.

Exchange Traded Funds

An Exchange Traded Fund (ETF) is a relatively new type of registered investment company, blending characteristics of all three types of registered investment companies described above. Exchange traded funds are bought and sold on the stock exchange for whatever price the market allows. The buy and sell price of an ETF closely mirrors its actual net asset value, and any significant arbitrage opportunities are quickly eliminated by day-traders and computer trading systems. Commonly, ETFs are often created as a type of index funds, meaning they follow a very specific type of asset. Below is a useful example.

One very popular ETF is the SPDR Gold Trust (ticker GLD). GLD holds physical gold and issues shares (fractional undivided beneficial interest in and ownership of the Trust) against the value of its investment portfolio. The objective of GLD is to reflect the performance of the price of gold bullion. Thus, if physical gold moved up or down 1%, the price for shares of GLD would likewise move the same 1%. Of note, GLD holds more than $70 billion dollars in physical gold bullion and traders exchange an average of 21 million shares daily. Thus, ETFs can provide investors with liquidity and exposure to commodity prices.

Mutual Fund Fees

All funds charge some type of fee to cover its operating expenses. The kind and amount of the fee varies from fund to fund. Some funds charge a “front-end load” or upfront fee paid at the initial purchase of shares, while others charge a “close-end load,” which is a fee charged upon the sale of a fund’s shares. Some funds may even charge both upfront and backend fees. Often times, close-end load fees are waived if an investor holds the shares longer than a prescribed period.

All funds will charge a periodic fee to cover expenses. With period fees, anyone holding shares in a fund over a certain record date becomes responsible for their percentage of that fund’s operating fee, which is computed as a percent of net asset value. Some funds may also charge 12-b1 fees, which are used to cover marketing expenses associated with the fund. 12-b1 fees are justified on the basis that increased marketing efforts attract new investment and are ultimately good for the fund. This has yet to be empirically proven, even with present-day funds managing trillions of dollars.

When considering investing in a mutual fund, it is important to consider the type and amount of fees charged by a particular fund. Since the fund will often charge a fixed percentage of the fund’s net asset value, it is important to compare funds based on their fee-adjusted historical performance. For example, if XYZ fund charges an annual fee of 1.5%, it must return at least 5.1% just to keep up with inflation (which was last reported at 3.6% in June of 2011).

Fortunately, financial regulations make it easier for investors to compare different funds by requiring standardized disclosures. For instance, SEC requires mutual funds to disclose their fees in a fee table at the fund’s prospectus and the Financial Industry Regulatory Authority (FINRA) further requires the categorization of mutual fund shares into three main share classes.

The three main share classes of mutual funds shares are: Class A shares which typically have a front-end load fee and no, or low, 12-b1 fees; Class B shares which typically have no front-end load fee, but a close-end load and a 12b-1 fee; and Class C shares, which usually have neither front or close-end loads, but have higher 12b-1 fees.

If you would like additional help comparing mutual funds, FINRA has created a useful tool for investors, which can be accessed at here. With this tool, you will be able to screen mutual funds based on various criteria and do side-by-side comparisons of different funds (which also shows you each fund’s associated fees). The SEC has also compiled additional information on mutual funds, which can be found at the SEC webpage