You may be hearing a lot more suddenly about mutual funds and fees. You may even be hearing about how it’s more efficient to be in index funds because their fees are lower. I’ve even sent out the excellent piece by John Oliver on retirement funds and fees.

But the question I keep hearing from clients when they ask me how they should invest their retirement funds or even non-retirement funds, is, “mutual funds are fine, right, that’s what you’re supposed to be in?” I then ask a few questions and realize sometimes people do not know what a mutual fund is or how it differs from an ETF (another term thrown around a lot lately) or an index fund. Let’s do a quick primer… impress your friends.

1. Qualified Funds – IRS qualified accounts hold money and assets that grow tax free. Some examples are retirement plans, IRAs, 529 college savings plans.
2. Non-Qualified Funds – all other money and assets usually held in bank or brokerage accounts
3. Brokerage accounts – hold NON-qualified funds and you can buy mutual funds, stocks, bonds, ETFs and other assets into the account. You can also hold cash in the account. This is the account you use if you are investing in the markets.
4. Mutual Funds – Money given to a mutual fund manager to buy stocks, bonds, or other assets and hold a lot of different ones all at once thus exposing the investor to greater diversity than he/she could get by investing in single stocks or bonds. There are equity (stocks) mutual funds and bond funds and natural resource funds, etc. Mutual funds have expense ratios, which is the amount the fund manager takes off the top to pay him/herself and they can have “loads” like 12b1 commission fees and management fees. Expense ratios can be 1-2% and loads are added onto that, thus eroding whatever gains you may make in that fund. It adds up quickly.
5. Index funds – A mutual fund where the holdings directly correspond to an index like the S&P 500 index or the Russell 2000 index. If 2% of the S&P500 is made up of XYZ company, then 2% of the S&P500 index FUND, will be made up of XYZ shares. Index funds have low fees, about 0.05 – 0.17% compared to 1.00-2.00 % on actively managed funds, and Index Funds have no load. In most cases (some say about 80% of cases) S&P index funds outperform actively managed (meaning a fund manager picks holdings in the fund) mutual funds.
6. ETFs – ETFs are like index funds split up into actual shares. You own one share of the mutual fund (in most cases, an index fund) if you own one ETF. The key with ETFs is they have even lower fees than index funds and can be traded on the market at any point when the market is open. A mutual fund is priced at the close of the market on the day you place the order.

Fees can kill your return over long periods of time, sometimes as much as 10% of your gain can be eroded by fees over long periods. It’s a lot of money. Money you need for retirement and most mutual funds do not outperform the S&P 500. Have you ever glanced at your retirement savings statement and wondered why it hasn’t gone up that much when you hear about the Dow going through the roof? It’s fees, usually.

In addition, the S&P 500 provides plenty of diversity through its 500 different companies. Pretty cool, huh? The first index fund was introduced in the late seventies and now more than 30% of all stock and bond mutual fund investment is in index funds. Remember, index funds are not a cure for everything and you need to think about your specific situation. It’s just an option most regular investors should consider.

Just owning mutual funds, and thinking you’re fine because you are supposed “own mutual funds” instead of picking specific stocks (which is true, the last thing you want to do is pick stocks), may not be enough. You have to know how much you’re paying for those mutual funds and whether they are performing enough to beat the index NET of fees. If not, try index funds. Cheap and cheerful.