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Which fund should I buy? That’s the question often asked by investors trying to select from the menu of mutual funds offered in their employer’s 401(k) plan or those seeking to diversify their portfolio across a range of financial products without having to purchase and manage a large number of individual stocks and bonds.

Mutual funds are facing increasing competition from exchange traded funds, but still dominate the market for pooled investments. U.S. mutual funds currently manage $11.8 trillion in assets, according to the 2011 Investment Company Fact Book from the Investment Company Institute. The money is spread over 292 million shareholder accounts held by 7,581 different funds.

But of this plethora of offerings, which fund should I buy? Here are five tips based on advice from a foundation run by the Financial Industry Regulatory Authority and dedicated to investor education.  

1. Types of Funds: While there are thousands of individual mutual funds, there are only a handful of major fund catergories: stock funds, bond funds, balanced funds investing in both stocks and bonds, and money market funds, investing in very short-term investments. When you buy a mutual fund, explains FINRA, you received a share in the fund, but do not directly own the underlying assets that make up the fund. As a part owner of the fund you are entitled to a share of the fund profits.
2. Active vs. Passive Management: An actively managed fund employs a professional management team to select in the underlying investments that make up the fund portfolio. In fact, says FINRA, the success and expertise of a specific fund manager may be the key reason you decide to invest in a fund. “The goal of a fund manager is to beat the market – to get better returns by choosing investments he or she believes to be top-performing selections,” said FINRA. “While there is a range of ways to measure market performance, each fund is measured against the appropriate market index or benchmark.” Fund managers are handicapped by their own management fees and trading costs, notes FINRA. “In fact, studies show that very few actively managed funds provide stronger-than-benchmark returns over long periods of time, including those with impressive short-term performance records,” said FINRA. “That’s why many individual invest in funds that don’t try to beat the market at all. These are passively managed funds, otherwise known as index funds.” Index funds seek to replicate a benchmark and incur lower management and trading costs.
3. Fund Objectives: The major categories of investment funds can be further broken down by fund objectives. Stock funds have goals such as growth, value, equity income, stock index, small-cap, mid-cap, or large-cap stock funds, sector funds, socially responsible funds or international or region-specific funds. Bond funds may specialize in duration, such as short-term or intermediate-term funds, or type, such as corporate, municipal or Treasury. Some bond funds strive to achieve high yields. Target-date funds are designed to help investors meet retirement goals. Funds of funds offer great diversification for a higher fee, and money market funds provide an alternative to a savings account, though they are not insured by the FDIC.
4. Fees: All mutual funds charge fees, says FINRA, and even a small percentage difference can make a big difference in growth over time. Management fees pay the portfolio management. 12b-1 fees, capped at 1 percent of your assets in the fund, pay for marketing costs, some shareholder services and sometimes employee bonuses. A miscellaneous category called “other expenses” covers transaction fees for fund trades and shareholder services not covered by the 12b-1 fees. Investors may also be charges account fees, redemption fees, exchange fees and purchase fees.
5. Prospectus: Nothing can better help you decide “which fund should I buy” than the fund prospectus. “You can find all of the details about a mutual fund – including its investment strategy, risk profile, performance history, management, and fees – in a document called the prospectus,” said FINRA. “You should always read the prospectus before investing in a fund.”

Investors interviewed by Millionaire Corner in January were most likely to turn to their financial advisor for help deciding “which fund should I buy?” Nearly 48 percent said they relied on their advisor to research mutual funds, while more than 44 percent look at the historical returns of the fund. More than one-third – 35.3 percent - look at the individual holdings that make up the mutual fund. Less than one-fourth researches the fund manager or rely on friends and family when trying to decide “which fund should I buy?”