Despite the majority of the financial media and advertising being devoted to stocks, trading or some “make money now” venture, mutual funds remain one of the primary choices of individual investors. Mutual funds offer the advantages of diversification by holding many securities, professional management and easy access to markets. Unfortunately, mutual fund investing is not necessarily simple, as there are a number if types of mutual funds with their own benefits and disadvantages.

A mutual fund is simply a portfolio of securities that pools the assets of individuals and organizations to invest toward a common objective such as current income or long-term growth. The fund may be an index fund which simply replicates a particular market based on a pre-established index (such as the Standard & Poor’s 500 for large US stocks) or may be actively managed with the portfolio manager making investment decisions in an attempt to create better performance than and/or manage the risk in its market area. Mutual funds are regulated by the Securities and Exchange Commission (primarily through the Investment Company Act of 1940), are owned by their investors and are overseen by a board of directors elected by the fund investors. After deducting investment, administrative and marketing expenses a fund passes all income and net trading gains to the investors, thus avoiding paying taxes itself.

The bulk of mutual funds (over 6,200 funds in 2009) and assets (over $10 trillion in the US alone) are in “open-end” mutual funds. These funds have a “continuous offering” of shares, which means that they stand ready to sell new shares to the public and to redeem its outstanding shares on demand at the net asset value, or the underlying value of the assets in the portfolio. Open-end mutual funds are very accommodating to all sizes of transactions, making them ideal for dollar-cost averaging and the regular payroll deductions of retirement plans. These funds are priced once a day, at the close of the markets, and all transactions received prior to pricing are priced and executed at that daily price.

This once-a-day pricing, along with the inability to submit transaction orders at a specific price, can be a drawback in volatile markets. Actively managed funds have been criticized for a lack of transparency in which investors are unaware of the fund’s changing investment emphasis over time; many “conservative” funds were exposed as having large technology holdings in 2000 or risky mortgage exposure in 2008. As technology has lowered transaction costs for other investment vehicles, open-end mutual funds costs, which were traditionally a big advantage, have come into question. Not only do open-end funds have a dizzying array of sales charges but economies of scale as the funds have grown have not translated into lower costs. (Index funds in general have lower costs and there are fund companies such as Vanguard which have a particular focus on low costs.)

Closed-end funds have a set number of shares and rather than the fund buying and selling shares, shares are sold on the market between investors. This allows the portfolio manager to focus on investing rather than also dealing with large swings in assets due to investor behavior. Some of these funds employ leverage, or borrowed money in addition to the money raised in the initial selling of shares, to increase exposure to the market. Since closed-end funds trade like stocks on an exchange, investors can use all the trading techniques available to stocks, such as stop loss and limit orders, to manage their investment. A commission is typically charged for each transaction, making small transactions expensive.

One of the biggest shortcomings of closed-end funds is that they trade at a price determined by the market, meaning there can be a large (20% or more) difference between the market price and the net asset value. This means that investors must be concerned about the impact of the trading premium or discount as well as the investment performance of the fund. In addition, while leverage can enhance returns in a rising market, it can magnify losses in a declining market. Issuance of closed-end funds has slowed considerably, with a total 627 funds holding $228 billion in assets in 2009.

Exchange-traded funds (ETF’s) are the newest form of mutual fund and have proven very popular, growing tenfold during the 2000’s in both the number of funds (800 in 2009) and assets ($777 billion in 2009). ETF’s are mostly index funds (although they are utilizing a broad array of index strategies, including markets that are not available through other fund types and “short” strategies that increase in value when a market declines) and trade like stocks. The unique feature of ETF’s is the ability of institutional investors to exchange the ETF shares for a proportionate share of the fund’s holdings, or to exchange shares of securities bought on the open market for shares of the ETF. This exchange feature is intended to keep the market price of the ETF very close to the net asset value; if those values diverge, an institutional investor will swoop in and profit from the difference, driving the market price closer the net asset value as a result. Like closed-end funds, a commission is applied to each transaction, although recent price competition has reduced those costs. The trading tools available with ETF’s, including options, have made them attractive to short-term speculators and long-term investors alike.

The “flash crash” of May 6, however, exposed an unnoticed weakness of ETF’s. Despite the exchange feature, ETF’s are distinct securities with their own supply and demand independent of the underlying index. For example, while the index for the overall US stock market (based on the prices of all the stocks in the index) never fell 10% in the flash crash, demand evaporated for many ETF’s that are based on that index. This caused the price of some ETF’s to drop by up to 90% in a matter of minutes, before recovering just as quickly. Many ETF owners who were employing trading techniques to protect themselves from a market decline instead suffered losses solely due to the dynamics of the ETF.

Mutual funds of all types offer undeniable advantages to individual investors. They are not, however, without their flaws, and each investor should be aware of the investment objective, performance, costs and the mechanics of any funds before taking the plunge.