In previous Investing 101 posts, I’ve mentioned mutual funds as the way many people invest in stocks and bonds. According to the Investment Company Institute (ICI), there were 7,923 mutual funds with 24,222 share classes on the market at the end of 2014. In your own employer retirement plan you may have between 20 and 30 mutual funds from which to choose. As I’ve spoken with folks, gathering information and stories for my book, I’ve learned that mutual funds are not fully understood. Given that they are an important vehicle for investing, it makes sense to delve into them a little deeper.

Mutual funds are pooled investment vehicles. In a pooled investment vehicle an investment manager “pools” money from many investors to create a portfolio of investments that are shared across all of the investors. If a manager invests in thirty companies, all of the investors own a portion of all thirty companies in the proportion that the manager has bought them. With pooled investment vehicles, there is a single price, called a unit price or net asset value, for owning a piece of the pool. The price is calculated daily, at the end of the day, based on the value of the investments owned by the pool. Mutual funds are the most prominent form of pooled investment vehicles, but there are several others.

Mutual funds are classified by the way in which they invest your money. Most focus on a particular area of investments. These include large company stocks, like those that make up the S&P 500, small company stocks, many of which you may not have ever heard named, international company stocks, bonds, and a variety of other investments.  Morningstar, an independent investment research firm, classifies mutual funds into over 54 different categories.

Funds may be actively managed or passively managed. Actively managed means the investment manager tries to out perform a particular market index, such as the S&P 500, by choosing the investments that she expects to have the best returns. Passively managed means the investment manager replicates the returns of the index. With a passively managed fund, you are assured you will get the return the index provides. With an actively managed fund, your returns may be higher or lower than the index. Actively managed mutual funds are generally more expensive than passively managed funds. The fee the investment manager charges to actively manage the fund is higher than it would be to manage a fund passively.

Most people encounter mutual funds in their employer sponsored retirement plan, but there are other ways to invest in them. Outside of your retirement plan, mutual funds are offered through stock brokerage firms, both full service (Merrill Lynch, Morgan Stanley, etc) and discount firms (Charles Schwab, ETrade, etc), banks and directly from the mutual fund company. If you purchase your funds directly from the fund company, there is no transaction charge. If you work with a brokerage firm or bank, there is usually a transaction fee to buy or sell shares. However, brokerage firms often offer “no transaction fee” funds. The brokerage firm is paid by the fund company, instead of you. These funds generally have higher expenses than the transaction fee funds, but if your balance is small, they still may be more economical.

Fund expenses are included in the price of a mutual fund. Expenses are deducted from the investment values to arrive at the net asset value of the fund. The expenses include the fee that is paid to the investment manager, a fee that is paid to the financial institution that holds the investments and calculates the unit price on the portfolio, administrative fees and expenses to sell the fund to investors. Fund companies often offer the same fund with different share classes, and the share classes are defined by the fund expenses. For example, Vanguard offers an S&P 500 index fund in three share classes. The investor share class has expenses of 0.17% of the fund value (if you own $1,000 worth, expenses would be $1.70) and is available to investors with less than $50,000 invested in it. The Admiral share class has expenses of 0.05% for investors with more than $50,000, and the Institutional share class has expenses of 0.02% for investors with $5 million or more. It is more cost effective for mutual fund companies to have fewer large accounts, and they pass the savings on to their larger investors.

In a single mutual fund fund, you can get a broadly diversified portfolio and professional management. The value of professional management is something that is often overlooked. Most of us have regular jobs that do not involve researching corporate financial records. So its difficult to put the time and attention into managing our own portfolios. Years ago, my husband, Jeff, thought he was a stock picker. To appease him, we cordoned off some money that he could manage any way he wanted. He did some research and bought a handful of company stocks. They were companies that appealed to his values. After the initial purchases though, he spent little time with his portfolio. As the value of the portfolio dwindled, relishing my “I told you so” moment, I pointed out that he had a day job, and he didn’t have the time or skill that professional investment managers devote to managing mutual fund portfolios. We’ve been devoted mutual fund investors ever since.

For most investors, mutual funds are an efficient and cost effective way to invest their money. Small investors (those with less than $250,000) will find it cost prohibitive and nearly impossible to create a portfolio similar to what can be created with a few mutual funds buying separately each company stock or bond. Even larger investors (those with more than $1 million) will find it difficult to get the diversification they want across all investment categories without using mutual funds. This explains why there are nearly $16 trillion invested in them.