A client asked me the differences among mutual funds, index funds, and exchange-traded funds or ETFs. My goal was to explain the key features, costs and risks that he’d need to understand, says Steve Pomeranz, CFP Thursday. More Trading Lessons Friday on MoneyShow.com.

A short history

While some trace the first-ever mutual fund back to 1774, the modern mutual fund began in 1924.  Interestingly, both 1774 and 1924 were the result of tough economic times.

Let’s start with the modern mutual fund, which was a formidable innovation with both positives and negatives.

The positives of mutual funds

First, let’s talk about the positives of mutual funds.

Mutual funds were promoted as vehicles of diversification that would increase the appeal of investments to smaller investors with minimal capital, back when most Americans believed stocks were too risky and solely for rich people.

These funds gave small investors the opportunity to pool resources and buy a basket of diversified securities, when the average small investor could not, on his own, afford to purchase enough stocks to build a diversified portfolio.

The modern mutual fund also broke the rich-poor barrier.  Back in 1924, professional money management was only available to the rich, but mutual funds brought professional investment advice to the masses, at an affordable fee that was a small percentage of the amount they invested.

Another positive innovation was the introduction of the open-end mutual fund, a really important milestone in mutual fund evolution. This new structure allowed investors to make withdrawals on demand, so one could tap into her assets and redeem shares at their true net worth at the end of each trading day.

Today, open-ended mutual funds hold the vast majority of the $3.6 trillion dollars invested and are the primary form of market participation for small investors. They offer a wide variety of investment options  for diversification and portfolio allocation between stocks, bonds, foreign equities, and what are called alternative investments.

The negatives of mutual funds

Now to the negatives.

In spite of their positive attributes, mutual funds have a few drawbacks that you should be aware of, so you can account for them in your investment strategy.

Realized capital gains

The first drawback relates to taxes. If the mutual fund manager sells some of the fund’s investments during the year, any realized capital gains must be paid to shareholders. While this seems reasonable, it can cause a regrettable situation where shareholders receive distributions and have to pay capital gains taxes, even if their account value is lower at the end of the year. Take it from someone who experienced this long ago. It is no fun to pay taxes when the value of your account has dropped.

I do have one strong warning for the fund investor. If you’re not careful, buying a fund near the end of the year may require you to pay taxes on other people’s gains. This happens if you buy close to the distribution date. The distribution will be made to you as a shareholder, but you would not have been in the fund long enough to earn those gains. Paying taxes on someone else’s gains is an awful thing. So be careful!

Active mutual fund management may charge higher fees

Here’s something else to consider.  In the U.S., more than half of all mutual funds are actively managed. However, active management strategies require more research, pay more in fees to brokers, and charge extra fees to pay the managers.

These extra fees could cause the fund to underperform relative to the market and may bite into your returns.

End of day pricing

Unlike stocks, mutual funds lack intra-day price transparency.  This means that the price of a mutual fund unit is recalculated at the end of each trading day and orders to buy and sell the fund are based on the end-of-day unit price.  So if an investor buys units at 10:30 am, he will not know the price paid per unit until after close of trading on that day. This may work for or against the investor.

Here’s an example of how this could go against you.  If you sold 100 units of a fund in the morning when the market was down “only” 30 points, you will receive the price as of the close of trading that day. If the market swings lower and closes down 500 points, your sale would reflect that substantially lower price. Ouch!

This concludes part 1 of this 2-part series.  Tune in next week for part 2!

To find out more, go to www.stevepomeranz.com