>Many investors today utilize mutual funds as part of their overall investment plan. Whether you must make your own mutual fund selections for your 401(K) or employer sponsored retirement plan, or use a professional investment advisor for other types of investment accounts, mutual funds can be an effective way to own baskets of stocks or bonds, with a small amount of investment dollars.Understanding Mutual FundsTo successfully invest in mutual funds, you should understand what they are and how they work, so let’s start with some basics.A mutual fund is a company that gathers money from many investors, and allocates that money by buying stocks, bonds or other assets. A mutual fund is like a big basket which holds a number of investments like stocks or bonds. When you buy a mutual fund, you actually buy a piece of the basket. In this way, you can own a small percentage of many different assets that you might not otherwise be able to afford on an individual basis. The value of the fund is based on the value of the assets it holds. As the stocks or bonds within the fund increase in value, the fund increases in value. Conversely, as the stocks or bonds within the fund decrease in value, the fund also decreases in value. Mutual funds only trade at the end of the day based on their net asset value (NAV). To determine the NAV at the end of the trading day, the mutual fund company looks at all of the assets that are in the basket, determines their value and divides that number by the total number of outstanding shares in the fund.Types of Mutual FundsMutual funds are divided into two categories: closed-end funds and open-end funds.Closed-end funds have a fixed number of shares issued to the public. If you want to purchase a piece of the fund, you have to purchase an existing share from a shareholder that is selling.Open-end funds have an unlimited number of shares. If you want to purchase a piece of the fund, the fund creates a new share and sells it to you. There are significantly more open-end funds than there are closed-end funds. Closed end funds can trade at values that are above or below their NAV, while open end funds only trade at their end of day NAV.Mutual Fund Research – Do Your HomeworkExpensesAll mutual funds have expenses. Some funds’ expenses are low while other funds’ have very high expenses. These include everything from the advisory fee paid the fund manager to administrative costs like printing and postage.With a little bit of homework, you can determine a fund’s expenses before you invest. This is important because those expenses can have a dramatic effect on your investment returns. The three expenses you should be aware of are loads, redemption fees and operating expenses.Loads are commissions or fees that can be charged either when you buy or sell a mutual fund. A front-end load (usually associated with class “A” shares) can be up to 8.5% of your investment. A back-end load (usually called redemption fees, are associated with class “B” shares) can also be quite high, but reduces over the years, the longer you keep your investment in the fund. Class “C” shares do not have a front or back end load, but have extremely high operating expenses deducted each and every year. These loads are usually used to pay a commission to the agent who sold you the fund. No-load funds, on the other hand, do not charge any commission at the front or back end.Operating expenses are generally stated as an annual percentage called the operating expense ratio. These fees cover the operating and trading costs for the fund, as well as management fees that go to pay the fund manager for his expertise and time.12(b)-1 are fees that cover advertising and distribution expenses for the fund. These fees are charged in addition to a front- or back-end load.When doing your homework, look for no load funds that do not charge 12(b)-1 fees, and have a low operating expense ratio. Studies have shown that load funds with high expense ratios perform no better than comparable no-load funds.TaxesAnother point to consider when investing in mutual funds is taxes. When a fund manager sells a stock or bond within the basket for a gain, IRS regulations provide that this gain be taxed to the shareholders of the fund. This means that a fund with a high “turnover” (a fund that buys and sells a lot within the basket each year) could have a great deal of gains that will be taxable to the shareholders. The tax gains are passed through to the shareholders who own the fund as of a specific date each year. This means that someone buying the fund just before the taxable distribution date, will pay the tax on the gain for the entire year, even though they did not own the fund all year. For more tax efficient funds, look for funds that have a low turnover rate.ProspectusBy law, a mutual fund company must outline all of the above expense information, and a great deal more, in their prospectus. A fund’s prospectus will specify a fund’s objectives and its past performance, information about the fund manager and the fees associated with the fund.Past PerformanceA common mistake for novice investors is to select a mutual based solely on its past performance record. Past performance may not be a food indicator of future performance, given possible changes in the global or domestic economy, the markets, or specific sectors the fund invests in. While past performance is a useful tool and one item to consider, it should not be the sole criteria. In many cases last year’s winners are next year’s underperformers.HistoryA fund that has been in existence five to ten years or more has a much better track record to assess than a relatively new fund that have not necessarily had performance measured during various economic or market periods. The longer the period of history you have to review, the higher the quality of historical performance data.Portfolio HoldingsWhen investing in mutual funds (or any investments), it is important to be diversified (see my blog titled “The Truth About Diversification”). Sometimes, owning a few different mutual funds may give the appearance of being well diversified, but on closer inspection, if the funds you own, each have major holdings in the same stocks, you may not be diversified at all. One test is to check the fund’s ten largest holdings. In the more concentrated funds, the ten largest holdings may comprise a significant percentage of the portfolio; in the less concentrated funds, they may hold a much lower percentage. Always know what specific investments your fund or funds own to remain diversified.Portfolio ManagerMutual funds are managed by a portfolio manager, or in some cases, by a team of portfolio managers. The success of a fund by an individual fund manager may be largely dictated by his performance. That is important to know, because a fund with a good track record historically, may perform differently in the future if the fund manager changes. It is always prudent to review the tenure of the fund manager in concert with past performance.StatisticsThere are several key statistical numbers that provide valuable information about a mutual fund. Fortunately, we do not have to calculate those statistical numbers ourselves as they are readily available.Alpha – measures the performance of a fund on a risk-adjusted basis. Alpha calculates a risk factor relative to a fund, and then compares that risk-adjusted performance to a benchmark (such as the S&P 500). A number is then assigned that reflects how that fund performs, relative to the amount of risk the investment is exposed to. For example, a positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%, or a negative alpha of -1.0 would indicate an underperformance compared to the benchmark of 1%. Beta – measures how a mutual fund performs in relation to the market as a whole. A beta of 1 for example, means that a mutual fund will move up or down in value in tandem with the market. A beta of 2.0 would mean a mutual fund would go up twice as much as the market when it the market increases, but it will also go down twice as much when the market decreases. That means this would be a much more volatile fund. A conservative investor would look for investments with a lower beta, rather than a higher one. Standard Deviation – measures the risk, or volatility of a mutual fund or investment. For example, a mutual fund might have a ten year average annual return of 8%. At first blush, that might look very good. But let’s say that this fund had a standard deviation of 20. This would tell us that although the fund had on average returned 8% over ten years, it did not earn 8% each and every year. Some years may have been up and some may have been down, but the average was 8% overall. The standard deviation number tells us that we should expect that this fund “could” return 20% more or 20% less than 8% in any given year, most, but not all of the time. There are certain times, more rare but possible, that a fund might move two or three standard deviations above or below the average 8% (60% more or 60% less). In a down market, that could be painful. The lower the standard deviation, the less risk or volatility a fund has. In conclusion, doing a little homework on mutual funds can really pay off later on not only in terms of performance, but also in terms of understanding risk and diversification. You will find that all of the information discussed above is easily available on a number of internet sites, including Yahoo, MSN, and Morningstar to name a few.