When you buy a fund you are trusting someone else to manage your money. Funds come in three broad flavours:

• Active Benchmarked: The fund manager has to beat the returns on an index. When you subtract fees managers usually fail to beat their index.
• Active Absolute Return: The manager has generate large positive returns no matter what happens in the market. During 2008/9 almost all of these funds lost money.
• Passive: the manager has the much easier task of copying the returns on an index.

Whatever flavour you choose the manager matters. If it's an active fund the difficulty is choosing which fund manager will perform best and this is notoriously difficult because past performance is a very poor indicator of future performance. If it's a passive fund you will probably go for the economies of scale and choose the cheapest and largest fund that tracks the market you want.

A nice measure of a fund manager is how long they have been in business. Active funds close when they fail, and many fail. For example in the UK over the last ten years the S&P Dow Jones Index Versus Active report found that only 45% of funds survived. To really kick the tyres ideally you would choose a fund manager that has been through a few business cycles and several market crises.

Now let's see another active fund but this time it can't buy just any stocks and bonds. It is benchmarked which means it has to beat its index. The management fee is a bit lower at 1.05%. This is the popular and successful Fundsmith Global Equity fund run by Terry Smith which uses the MSCI Global equity index as a benchmark that it aims to beat. It does so by choosing 30 stocks which it thinks will perform more strongly than the MSCI World index as a whole.

And the third fund is the largest passive fund in the world: SPY. It is huge, managing $265 billion at the time of writing. The ongoing fee is the lowest of these three examples by far at 0.09% per year which is an order of magnitude (19 times!) cheaper than the absolute return fund above. The manager isn't even mentioned, it's simply listed as "Management Team" because it is irrelevant. This fund's sole aim is to track the price movements of its benchmark, the S&P 500, as closely and as cheaply as possible.

If a fund is tracking (passive) or hopefully beating (active) an index then almost everything about the fund is determined by the index. A FTSE 100 tracker will buy large companies that trade on the London Stock Exchange. An S&P 500 tracker will buy large US companies. The risk and return is driven by the choice of index, or benchmark. Different types of benchmark have different risk and return characteristics that you should be aware of.

• Share Indices: Shares are more risky than bonds, and emerging market (EM) shares are more risky than Developed Market (DM) shares. So the region that the share benchmark references matters a great deal. Some indices buy the stocks of only one country, such as the UK or US or Japan. And even more fine-grained indices exist for sectors or industries within a country or region.
• Bond Indices: Bonds are tradable loans where you get your money back and are more predictable and usually less risky than shares, but come with their own risk factors. The primary consideration is the credit worthiness of the company or country that issued the bond in order to borrow money. Government bonds are very safe if issues by the US or UK but not safe at all if issued by Venezuela which may well not give you your money back. Corporate bonds can be safe (investment grade) or risky (junk bonds) and pay you extra for taking more credit risk. Duration also matters with longer duration funds being more sensitive to interest rates and having larger daily price fluctuations or volatility.
• Other Indices: These encompass commodities, real estate, Environmental Social and Governance indices that select companies with green credentials and good corporate governance. The Index company S&P Dow Jones maintains over 1 million indices spanning almost every conceivable significant financial market on Earth.

We buy funds to generate return but like an unwelcome party guest each fund brings risk in our portfolio. By risk we mean the risk of capital loss as our investments fall in value. The standard measure of risk is the typical daily percentage price fluctuation, or volatility, measured as a percentage. Here are 18 Vanguard funds sorted by their volatility. You may notice that shares are at the top, and are most risky, while government bonds are at the bottom and least risky. In theory the riskier the asset the more potential return it generates, but this comes with the higher risk of losing money.

There are many risk measures but volatility is easy to calculate for any asset that has a positive price. For bonds there are additional risk indicators. In order to measure creditworthiness rating agencies give a standardised letter code to indicate how likely you are to get your money back. The highest credit rating is AAA, then it goes through the ranks of investment grade ratings via AA, A, BBB, then we jump down to junk ratings of BB, B, CCC, CC, and C. Bond prices also rise when interest rates fall and fall when interest rates rise. Their sensitivity to interest rates is measured by their duration. A 0.1% fall in interest rates will increase the price of a bond with two years duration by 2 x 0.1% or 0.2%. The same rate fall would increase the price of a bond with ten years duration by 10 x 0.1% or 1%. A larger duration means bigger rate-driven price fluctuations and more risk.

A final consideration with funds is the liquidity of the asset they are buying. Liquidity is how long it takes to sell an asset in return for cash. During a crisis market liquidity notoriously dries up as few people want to buy crashing assets. The commercial real estate is one such illiquid market. Have you ever tried selling a shopping centre? I can take ages. Corporate bonds generally take longer to sell than shares and EM assets take longer to sell than DM assets. If everyone is selling their share in a fund as its market crashes the fund manager must sell assets to redeem the fundholder shares. This may be impossible if the fund is illiquid. So it pays to be aware of this danger.

Do you really need to buy this fund? Sometimes we buy things for the wrong reasons, for example if they are mentioned in the news. Sometimes we buy things simply because we are bored. However simplicity is a virtue. Jack Bogle recommends only holding two funds!

"Deep down, I remain absolutely confident that the vast majority of American families will be well served by owning their equity holdings in an all-U.S. stock-market index portfolio and holding their bonds in an all-U.S.bond-market index portfolio" In Jack Bogle, The Little Book Of Common Sense Investing, Chapter 18.

Your portfolio is an ecosystem that must be balanced. Too much of one asset type, one country's shares or one sector will increase the risk of the portfolio. When adding a new fund consider whether it will diversify the risk of your portfolio or increase the risk. Stocks, even international stocks, tend to be highly correlated with one another - their prices often move up and down in lock-step. This is why mixing bonds and stocks diversifies your portfolio.

Also consider whether you are buying the fund because you think its price will increase (capital return) or because it generates a high income. If so, why?

Most funds charge a flat fee which is a percentage of your investment each year. If you invest £100 and the fee is 1% per year you would pay the fund manager £1. This doesn't sound like much but fees compound just like returns. This means that over forty years that innocuous sounding 1% will eat 49% of your return!

Generally passive funds charge much less than active funds (passive funds usually around 0.2% per year and active average about 1.3% per year) with some charging as little as 0.07% per year. In fund documentation you will see the letters OCF which stands for Ongoing Charges Figure. This is your annual management fee.

Remember that while you can't control markets you can control fees. Don't pay more than you have to because fees eat away at your returns every year.

Some funds also charge fees to buy the fund (entry fees) or leave the fund (exit fees). These funds are best avoided, so check for these two in the fund documentation.

Taxes may also affect your choice of fund. For example capital gains and income are often taxed differently. If you hold your fund inside a tax wrapper, such as an Stocks and Shares Individual Savings Account (ISA), then you won't have to worry about this.

The size of a fund matters because funds that are too small are not financially viable and will close. Funds close if they fail to attract investor funds and grow above this threshold. The size of a fund, its Assets Under Management (AUM), is the amount of money in the communal pot which it uses to buy assets. The bigger the AUM the more money the fund manager makes. Say the fee is 1% per year, 1% of a £1 million pot is only £10,000 which won't pay for much in overheads. This is why a fund needs to be at least £20 million or more to be worthwhile for the fund management company. This is also why the larger a passive fund the lower the fee the manager can afford to charge.

If a fund is small then it is worth checking when the it was created. Its small size may just reflect the fact that it has not had long to draw in funds. If it is small and has existed for some time that should ring alarm bells.

Leveraged funds offer twice, three times, or even more of the daily return of an index. For example the ProShares Ultra S&P 500 ETF (ticker SSO) aims to pay you twice the daily return of the S&P 500. 

The most popular leveraged funds are short an index which means they pay minus 2 times or minus 3 times the daily return of the index. The fund above pays -3x the daily return of the S&P 500. Investors buy these short indices if they think an index will fall. Leveraged funds that have a positive multiplier are bull funds or ultra funds (e.g. Direxion Daily Small Cap Bull 3X Shares ETF), negative multipliers are bear funds or ultrashort funds (e.g. ProShares UltraShort S&P 500 ETF).

Another problem with these levered funds is that their fees are usually much higher than the straight tracker for an index.

If you are a sterling investor buying foreign assets exposes you to currency risk. This can either boost or reduce your returns:

• Sterling Weakens vs. foreign currency: boosts the value of the foreign asset in sterling.
• Sterling Strengthens vs. foreign currency: reduces the value of the foreign asset in sterling.

This is more of a problem for assets such as bonds whose volatility is less than the volatility of developed market currencies. For example say a US bond fund has a volatility of 2%. The volatility of sterling versus the US dollar is about 10% which is five times higher, so currency volatility would swamp the fund volatility. Equity usually has a volatility of around 20% so a US equity fund would move around more than the currency.

Some funds have a built in currency hedge which removes the effect of currency fluctuations. This is probably worthwhile for foreign bond funds, less so for foreign equity funds although they do exist. For example the ETF on the right tracks the MSCI Japan equity index and is currency hedged for sterling investors while the one on the left is not hedged and bears the full currency risk of sterling versus the Japanese yen.