Are you aware of what goes into managing investment funds—and the fees that go along with it?

It’s important to know the ins and outs of the different styles (and fees) in managing investment funds.

Below we share information on five types of funds that investors find in the marketplace. This information will help you pick the types of investments that make the most sense for your portfolio. It will also help you avoid certain types of funds that entail excess risk.

Managing investment funds: Mutual funds

Mutual funds pool money collected from many investors and use the money to invest in securities, mainly stocks and bonds. The shareholders participate proportionally in the gain or loss of the fund.

Mutual funds let small investors access professionally managed, diversified portfolios that would be difficult for them to create on their own. However, the funds in turn charge investors management fees.

You can think of Exchange-Traded Funds (ETFs) as highly efficient mutual funds (see more below). Their fees are lower than those of mutual funds because investors don’t pay for active management. Instead, ETFs aim to mimic the performance of a market index, by holding the same securities in the same proportions used to calculate the market index.

Managing investment funds: ETFs

Exchange traded funds (ETFs) are set up to mirror the performance of a stock market index or sub-index. They hold a more or less fixed selection of securities that represent the holdings that go into the calculation of the index or sub-index.

ETFs trade on stock exchanges, just like stocks. That’s different from mutual funds, which you can only buy at the end of the day at a price that reflects the fund’s value at the close of trading.

As well, shares are only added or removed from ETFs when the underlying index changes. As a result of this low turnover, you won’t incur the regular capital gains taxes generated by the yearly distributions most conventional mutual funds pay out to unitholders.

Here’s a good general rule to follow when choosing investments: Simple is better. The easier an investment is to explain and understand, the less likely it is to harbour hidden risks and costs that can only work against you. As the old investor saying goes, “Stick with plain vanilla.”

For the investment industry, the rule works in reverse: The more complicated, the better. Each new feature provides a profit opportunity for the institution that sponsors the investment. It’s particularly important to keep this in mind with ETFs.

Managing investment funds: Bear funds

Investors can use special ETFs called bear funds to hedge their positions in a market downturn.

A bear fund is a type of ETF that is designed to rise in market downturns. A bear market is a situation where stock market averages trend downward for a lengthy period. The opposite of a bear market is a bull market.

Managing investment funds: Bond funds

Bond funds are ETFs or mutual funds that invest most of their assets in government or corporate bonds.

If you need steady income and want to hold the best bond funds, we advise you to focus on those holding bonds with short-term maturity dates. That’s because bonds with shorter terms face a lower risk from interest-rate increases. You should also avoid funds that take part in any kind of speculative trading.

Managing investment funds: Asset allocation funds

Asset allocation funds are mutual funds that can shift their portfolio allocations between stocks, bonds and cash in order to capitalize on perceived investment opportunities in any one of those classes.

For example, if the managers feel that the bond market is depressed and poised for an upswing, they may overweight the portfolio in fixed-income investments for a few months to take advantage of the change. We don’t recommend asset allocation funds.

Some managers use judgment calls to choose between stocks, bonds and cash, while many use a so-called “black box” — a computer program that makes trading decisions based on a preselected set of rules for interpreting financial statistics. Computer modelling makes this investment approach sound scientific, but it is just as likely to detract from a portfolio’s long-term return as it is to add to it. We also don’t recommend black box investments.

What are the riskiest funds you’ve added to your portfolio with success?

Most investment funds come with limited risk. Some, however, can eat your profits as fast as you can make them. Have you lost money in any of these funds? What did you do to change things?