Mutual funds come in three flavors: open end (actively managed), open end (passive) closed end (actively managed), ETF
Open End mutual funds (actively managed)
When people speak generically about funds, they typically talk about open end funds that are actively managed. these are the funds listed in the daily newspaper under "mutual funds." There are over 10,000 funds, most of them "look alikes." In other words, there are only a few basic types of funds and there are hundreds within each type. For example, if we look inside the portfolios of most large-cap growth funds, we would find that most hold Microsoft, Intel, Cisco and maybe a dozen other companies that they all favor. These funds are similar and will move up and down together. The main feature of actively managed funds is that a professional manager is watching the portfolio each day and makes purchases and sales that hopefully generate profit for the investor. Overall, these managers, when taken as a whole, do not generate profit for their investors. A few do, most do not. Therefore, many educated investors will tell you to buy index funds because they you don't pay for the manager or for their mistakes.
Why do so many people buy these types of funds if only a few fund managers deliver value to investors? Because investments are sold and not bought. These funds advertise heavily to distribute their wares through stockbrokers or financial planners. So they spend millions on advertising and commissions (that the investors pays) in order to sell their funds and it works. Some of these funds do have winning managers but the majority are simply costly ways for an investor to get involved in the market. The true cost of some growth funds when all is considered—the management fee, the 12b-1 fee, the turnover costs—can easily be 5% annually.
Open end simply means that you can sell your shares back to the fund any day. The fund stands ready to retire shares it buys back or create new ones as investors want to buy.
Index Mutual Funds (open end passive)
In 1975, John Bogle presented an idea to the board of directors of the newly formed Vanguard Group — create an extremely low-cost mutual fund that would not attempt to beat the returns of the stock market as measured by Standard & Poor's 500 index; instead, it would attempt to mirror the index as closely as it could by buying each of the index's 500 stocks in amounts equal to the weightings within the index itself.
In his presentation to the Vanguard board, Bogle presented the historical data then available to him. In his account of The First Index Fund, Bogle writes:
"I projected the costs of managing an index fund to be 0.3% per year in operating expenses and 0.2% per year in transaction costs. Since fund annual costs at that time appeared to be about 2.0%, I concluded that an index fund should reasonably be expected to provide an annual return of +1.5% above a managed fund."
In the intervening years Bogle has proven to be even more correct about indexing than he had predicted he might be. Since then, the gap between the performance of the market and the performance of actively managed mutual funds taken as a whole has actually been significantly wider than the 1.5% theorized by Bogle in 1976. During the 1990s, the total shortfall between actively managed mutual funds and the market as measured by the S&P 500 has so far been a whopping 3.4% per year.
The differential between actively managed funds and passively managed index funds is very easily explicable. The difference does not come from the actively managed mutual funds being run by buffoons. Not at all. The stocks that mutual fund managers pick end up being more or less average performing stocks. Bogle analyzes the differential as being determined by four factors: costs, turnover, sector, and cash reserves.
During the 1990s, the S&P 500 has provided an annualized return of 17.3%, compared with just 13.9% for the average diversified mutual fund. This 3.4% is explained first by understanding the fact that during the 1990s the S&P 500 (essentially an index of the 500 largest companies in America) has produced returns that are better than the rest of the market. One must first look at an index of the whole stock market, the Wilshire 5000 Index. The return for the Wilshire 5000 has been 16.3% during the 1990s, so you should count 1.0 percentage points as a "large-cap effect," bringing the gap between managed funds and the Wilshire 5000 down to 2.4%.
The expense ratio of the average fund, that is the average amount of expenses that a fund charges its shareholders every year, was about 1.3% during the period. (Over the last couple of years expense ratios have been rising further and currently stand at 1.5%.) By comparison, the Vanguard S&P 500 expense ratio is 0.19%.
Many funds also buy and sell their holdings at a rapid pace. Currently this turnover occurs at an average rate of 85% per year. This means that at the end of every year the average mutual fund only owns 15% of the same shares with which it started the year. The transaction costs involved in buying and selling so many shares every year result in an additional 0.7% of return disappearing every year.
Additionally, fund managers, believing that they can time the market, hold an average of about 8% of their portfolios in cash reserves. This practice has been a very expensive penalty during the bull market of the 1990s. This holding of cash reserves essentially explains the rest of the differential between mutual funds and the market.
S&P index funds have garnered a lot of attention over the last couple of years for good reason. The Vanguard S&P 500 fund has outperformed over 90% of all domestic equity mutual funds over the past three and five years (and a much higher number if you include bond and international equity funds). But S&P index funds certainly aren't the only index funds, and in fact may not even be the best.
Closed end (actively managed)
Closed end funds differ from open end funds in this respect — when you buy and sell shares, you do not buy and sell from the fund. You buy and sell with another investor, the same as when you buy and sell shares of a stock. Therefore, the fund itself is not impacted when people buy and sell their shares as they don't get involved. Here's the advantage. When the markets are falling and people get worried and sell, the fund does not need to buy back their shares. The fund does not need to sell stock in a falling market the way an open end fund does. While the open end fund must meet redemption requests, the closed end fund does not. Therefore, closed end managers have a freedom that open end managers do not.
This results in the following pricing difference. An open fund, because it stands ready to buy your shares at any moment, is priced equal to the underlying investments it owns. For example, if the fund holds $100 million of securities and you own 12% of their fund shares, your 1% is worth exactly $1 million. Closed end shares may trade at a discount or premium to the underlying value (called net asset value) because the fund has no agreement to buy back your shares. the value of your shares are worth whatever another investor will pay. There are some investors who make a science of buying shares at a discount and then selling later when the discount has widened.
But, because these funds are actively managed, costs are still high, much higher than index funds discussed above or ETFs discussed bellow
ETF (exchange traded fund, passive, closed end)
These are like index funds and come in many flavors. For example, you can buy a Korean ETF that holds a basket of Korean companies or a technology ETF or a leisure ETF. These are in fact sector funds which focus on one sector or one index (e.g. S&P 500) and the basket of securities changes only to match the index. There is no active management. As a consequence, fees are very low. Additionally, like closed end funds, these trade on the exchange and are bought and sold like shares of stock. ETFS have the combined advantages of index funds and closed end funds and have become an incredibly popular alternative very quickly.