Mutual funds have become more numerous than stocks. There are thousands of them out there competing for your investing dollars. Luckily, though, there's a simple way to capture most of the market's returns: Buy an index fund. And if you're looking to do better than that, we've got a few strategies for you.

Introduction to mutual funds
A mutual fund is simply a collection of stocks and/or bonds. When you buy shares of a fund, you buy a very small portion of that collection of investments. Most mutual funds are actively managed, meaning the mutual fund shareholders pay a mutual fund manager an annual fee to buy and sell stocks or bonds within the fund.

Although you would think that mutual funds provide benefits to shareholders by hiring (alleged) expert stock pickers, the sad truth of the matter is that the vast majority of mutual funds underperform the average return of the stock market. Over time, because of their costs, about 80% of mutual funds have underperformed the stock market's average overall return.

On the whole, the average mutual fund returns about 2 percentage points less per year to its shareholders than the general stock market does. The market's historical returns are roughly 11% per year, but managed mutual fund shareholders as a group can expect to see any return reduced by the approximate costs imposed by the funds.

Advantages of mutual funds

  • Diversification. Buying a mutual fund provides instant holdings of several companies in a variety of sectors.
  • Liquidity. Like individual stocks, a mutual fund investment can be converted into cash at your request.

Disadvantages of mutual funds

  • The Wisdom of professional management. That's right -- in most cases this is not an advantage. The average mutual fund manager is no better at picking stocks than the average nonprofessional, but he charges fees as though he is.
  • No control. Unlike picking your own individual stocks, a mutual fund puts you in the passenger seat of somebody else's car.
  • Dilution. Mutual funds generally have such small holdings of so many stocks that insanely great performance by a fund's top holdings still doesn't make much difference in a mutual fund's total performance.
  • Buried costs. Many mutual funds specialize in burying their costs and in hiring sales representatives who do not make those costs clear to their clients.

Fund classifications
Mutual funds come in every size, shape, and color, and if you're participating in your company's 401(k) or 403(b) plan (and you should be!), you've probably noticed that already.

Here are some types of mutual funds:

  • Bond funds. Bond mutual funds are pooled amounts of money invested in bonds. Bonds are IOUs, or debt, issued by companies or by governments. A purchaser of a bond is lending money to the issuer, and will usually collect some regular interest payments until the money is returned. Usually the amount of interest paid (the coupon) is fixed at a set percentage of the amount invested; thus, bonds are called fixed-income investments.
  • Balanced funds. Balanced funds mix some stocks and some bonds. A typical balanced fund might contain about 50% to 65% stocks and hold the rest of shareholders' money in bonds. It is important to know the distribution of stocks to bonds in a specific balanced fund to understand the risks and rewards inherent in that fund.
  • General equity (stock) funds: styles and sizes. Stock or equity mutual funds are pooled amounts of money that are invested in stocks. Stocks represent part ownership, or equity, in corporations, and the goal of stock ownership is to see the value of the companies increase over time. Stocks are often categorized by their market capitalization (or caps), and can be classified in three sizes: small, medium, and large. Many mutual funds invest primarily in companies of one of these sizes, and are thus classified as large-cap, mid-cap, or small-cap funds.
  • International/global funds. International funds invest in companies whose headquarters are beyond the fair shores of this great nation. (There are, of course, many other great nations.) Global funds invest in both U.S. and international companies. In general, international and global funds can be more volatile than domestic funds.
  • Sector funds. Sector funds invest in one particular sector of the economy: technology, energy, banks and finance, computers, the Internet, llamas. (Just kidding. No one has yet started the Llama Fund, though it's only a matter of time.) Sector funds can be extremely volatile because the broad market will find certain sectors very attractive and very unattractive -- often in rapid succession.

Load and no-load funds
Load refers to the sales charge many funds incur to compensate the broker for his or her "services" in selling the fund to an investor -- and this is in addition to annual expenses! No-load funds skip the middleman and are sold directly to the investor with no sales charge. The variety of no-load funds available gives you all the fund choices you need to maximize your potential returns. Studies show that no-load funds perform as well or better than load funds anyway, so resolve, from this day forward, that you buy only no-load funds.

You can buy no-load funds directly from the mutual fund companies. (Give them a call or check their websites for information.) Some discount brokers also sell selected no-load funds with no transaction fees.

Buy an index fund
Remember the introduction to this article? Here's a reminder: "Buy an index fund!"

Stock index funds seek to match the returns of a specified stock benchmark or index. An index fund simply seeks to match "the market" by buying representative amounts of each stock in the index, rather than paying a manager to make bets on individual stocks, sectors, or investment strategies. Index funds do not even attempt to beat the equities market -- they seek to come as close as possible to equaling it. The key to the unquestioned superiority of index funds is their extremely low expenses -- they charge very low fees for providing the market's returns.

Sound simple? Sound like aiming too low? It isn't. Almost all actively managed equity mutual funds over time lose to the market averages. And many funds that do manage to beat the market's return typically do so for only a very short time, and then quickly reverse course. Only the best managers find ways to outperform the markets consistently.

The largest and most well-known index fund is the very first one, the Vanguard S&P 500 Index Fund. This fund, started by the Vanguard Group, nearly matches the returns of the Standard & Poor's 500 Index and has beaten the performance of the majority of all mutual funds over the years. Many other mutual fund companies now offer S&P 500 index funds.

There are numerous other indexes, however, and therefore numerous other index funds. There are funds to match mid-cap indexes, small-cap indexes, small-cap growth indexes, foreign indexes -- you name it. These other index funds in all probability will outperform most managed funds that invest in the same sectors of the market.

One caveat though. Due to the recent popularity of index funds and exchange-traded funds (ETFs), several fund companies are charging higher fees than necessary. If you're considering an index fund (and you definitely should if you're investing in mutual funds), always remember to compare its expense ratio against other similar index funds.

What should you do if you're in a 401(k) plan and no index fund choice is offered? Make your voice heard! Tell your company that an index fund option is necessary for your company to live up to its commitment to its employees.

What about other funds?
While a good, broad market index fund is fine for most fund investors, there are some actively managed funds worth your attention. After all, investing greats like Peter Lynch, Marty Whitman, and Sir John Templeton managed very successful mutual funds.

With respect to actively managed funds, we believe that if you ask and answer a consistent set of questions, you can home in on the industry's best and brightest and leave your friendly neighborhood stock jock in the dust, where he'll be crying over his outsized brokerage bill.

As you go fund shopping, then, put these two traits near the top of your list.

1. A manager with a successful track record of at least five years
Lots of otherwise savvy folks get hung up on a fund's past performance, but if a seemingly impressive track record doesn't belong to the manager who's currently calling the shots, that showing -- in the immortal words of Elvis Costello -- means less than zero.

It's the manager's performance, not the fund's, you should focus on, and while there are a handful of exceptions, five years is just about the minimum amount of time a manager needs to weather a least one market cycle -- and to show he or she has the right stuff.

2. A reasonable expense ratio
Even if you do bypass a brokerage commission, you'll still have to pony up for a fund's expense ratio. All things being equal, the lower the better. But before you assume that means you should invest in a low-cost index fund, remember that with index funds, the most you can realistically expect is to underperform the market each year by about the amount of your annual expenses.

The upshot? While index funds certainly have their place, savvy investors can shoot higher without paying for the privilege. With that in mind, consider that while the typical domestic-stock fund will ding you roughly 1.5% each year, you can find excellent funds that cost less than 1%.

To learn more about mutual funds, consider checking out our fund newsletter service, Motley Fool Champion Funds. Each issue has a new fund recommendation, along with analysis and commentary about the fund industry.