According to the latest numbers, today almost half of us in the United States, over 50 million households, own at least one mutual fund.  With over 10,000 funds from which now to choose and totaling $10 trillion in assets, we have made mutual funds our largest investment comprising nearly 70% of our collective nest egg.

With numbers like that, it is no wonder that mutual fund companies are amongst the world’s most profitable.  Think about it: on average we pay around 1% of our assets every year to these fund companies for payment for their services.  That is a total of $100 billion or $2,000 per household!  That’s like buying a brand-new HDTV every year.  In return, those funds are supposed to earn more for us than we could get by investing by ourselves.

But do you know what you are getting for that money?  And do you know the difference between the kinds of funds?  For $2,000 a year, you owe it to yourself to be as knowledgeable as possible.

In simple terms, mutual funds come in three flavors: actively managed, passive or index, and exchange traded funds.

Actively Managed Mutual Funds

The most prevalent kind of mutual fund, actively managed funds are those in which a manager picks stocks in an attempt to try and beat a benchmark, typically the S&P 500.  The biggest mutual fund “families” in this category are Fidelity, American Funds, Dodge and Cox, and Pimco.  There are numerous strategies that the manager employs to buy and sell stocks that he/she thinks will outperform the market.  As I have written here numerous times (here and here), nearly all of these actively managed mutual funds do not deliver for investors because these funds underperform their benchmarks when you factor in that 1% fee.

Passive or Index Funds

Of those of us that own mutual funds, 31 percent (15 million households) also own at least one index fund- a fund that simply seeks to track the performance of a broad basket of stocks such as the S&P 500.  Because these funds are not “active”, they tend to trade infrequently, and as a result, you pay less for them, around .25% or a quater of what you pay for actively managed funds.

As of 2007, such 373 different index funds managed total assets of nearly $860 billion, a small drop in the bucket compared to the overall dollars invested in mutual funds, but they are growing quickly.  Vanguard is the leading index fund provider.  As I have said before, you have to be careful that you are not paying more than you have to for these funds.  There are 150 mutual funds that just track the S&P with fees that range from a high of 1.50% to a low of .07%.  Don’t be the guy paying 1.50% for exactly the same product.
Exchange Traded Funds

Exchange traded funds (ETF) are a relatively new quiver in the individual investor arsenal.  And the small numbers of us that own them reflect the confusion around them.  Of households that own mutual funds, only an estimated 4 percent also own ETFs.  They have grown in popularity over the past few years and there are now close to 700 ETF’s with over $500 billion in assets.  Barclay’s iShares is the leading ETF company by far.

These funds are akin to index funds in that they allow you to track broad indexes as well as specific strategies, such as gold or China, relatively cheaply.  While they are similar to index mutual funds in many ways, there are a few key differences.  ETF’s trade on an exchange and can be bought and sold like a stock throughout the day, unlike mutual funds which get priced at the market close.  Most important, ETF’s track the performance of baskets of stocks so the biggest advantage is that you can get “actively managed” strategies for “passive” fees.

I have written at length about the relative performance and value of indexing versus active mutual funds.  Whatever your strategy, be an informed consumer and know how much and what you are paying for your mutual funds.  You might be surprised to learn that you are paying several thousands of dollars a year, which adds up to hundreds of thousands of dollars over the course of your investment life.

If you would like to see more data check out this great data and the 2008 Mutual Fund Fact Book from the Investment Company Institute, the national association of investment companies that includes mutual fund companies and ETF providers.