Those who wish to invest in stocks and bonds but don’t have the time to research individual companies or industries often turn to two basic investment vehicles: mutual funds and exchange-traded funds, better known as ETFs.
Mutual funds pool together money from lots of different investors to buy a collection of securities, typically stocks and/or bonds, which have a common characteristic. They might hold stocks of companies that are considered large and established, for example, or they might hold short-term U.S. bonds. As the individual securities that make up the collection, or portfolio, change in value from day to day, the mutual fund’s shares change in value, too.
The price of one share of a mutual fund is called the net asset value (NAV). NAV is calculated by dividing the total value of all the securities in the fund’s portfolio by the total number of shares owned by all the mutual fund’s investors. If a fund’s total portfolio value is $1 million and it has 100,000 shares owned by investors, the NAV, or the value of each share, is $10. NAV is calculated once at the end of each trading day. (Related: Learn more about mutual funds)
ETFs are also a collection of securities, typically stocks and/or bonds, that generally mirrors an index, such as the Standard & Poor's 500® stock index. But unlike a mutual fund, an ETF’s share price changes throughout the day as the individual securities in its portfolio change in value. (Related: Learn more about ETFs)
A number of mutual funds and ETFs try to match the performance of an equity index like the S&P 500, which consists of the stocks of 500 large U.S. companies (as measured by market capitalization, which is the number of outstanding shares multiplied by the current market price per share), or a large bond index tracking the performance of many types of U.S. bonds with maturities longer than one year.
With an index fund, “the only difference between your performance and the performance of the index is the amount of the management fee paid — usually less than 0.50 percent per year,” said Gabriel Pincus, president and portfolio manager of GA Pincus Funds in Dallas.
Index funds are considered passively managed funds, because the securities within the portfolio are not actively traded by a fund or portfolio manager.
By contrast, other mutual funds and ETFs often try to beat the performance of an index and trade the securities in them at the discretion of a portfolio manager; these are considered actively managed funds. Actively managed funds are generally more expensive because they rely on more human involvement, typically research and ongoing management of the holdings in the fund. They are often viewed as being riskier. However, they also offer the chance for better returns on investment than the market average. (Related: A multi-manager approach to retirement investment)
Some mutual funds and ETFs are specialized. Instead of investing in the overall stock market or the overall bond market, they might target certain industry or market sectors, such as biotechnology, healthcare, or energy.
These kinds of funds might also focus on a specific region (Europe or Asia) or country (China). An emerging market fund, for example, might include only securities from South Korea, Mexico, India, or Brazil, which are less developed than markets in the United States and much of Europe. Specialty funds might also focus on a specific type of investment, such as commodities (e.g., grains, metals, and oil) or classes of bonds (e.g., Treasurys, corporate, and high-risk).
Purchasing mutual funds and ETFs
Many investors buy shares of mutual funds through an employer-sponsored retirement program, including a 401(k) or 403(b) plan, and ETF shares are sometimes available through these plans as well. Each plan will have its own selection of investments for plan participants to choose from. (Related: What is a 401(k) plan?)
If you are not investing through an employer-sponsored plan, you can purchase shares on your own through a brokerage firm or a registered financial professional. Some sell their own, or proprietary, funds as well as other investment firms’ funds. In some cases, it is possible to purchase a mutual fund or ETF directly from the company that issues it.
Depending on the fund you buy and where you buy it, you may or may not have to pay a sales charge called a commission. When you buy a fund company’s own proprietary funds directly from the company, you generally will not pay a commission; these funds are commonly referred to as no-load funds.
All mutual funds and ETFs have an expense ratio, which is an annual fee that all investors pay based on a percentage of their assets invested in the fund. This fee covers the costs to manage, administer, and operate the fund (including 12b-1 fees related to marketing). If you have $10,000 invested in a fund with a 0.20 percent expense ratio, then you will pay $20 a year to hold that investment. Generally, the expense ratio is separate from any fees you pay to buy or sell shares.
ETFs often have lower expense ratios than mutual funds because they are generally not actively managed. Mutual funds that are passively managed often have expense ratios that are just as low as those of ETFs. Similarly, actively managed ETFs can cost just as much as actively managed mutual funds.
Some mutual funds also have a transaction fee called a front-end load, which is assessed when you buy the fund, or a deferred sales charge, which is assessed when you sell the fund. A short-term redemption fee of 0.5 percent to 2.0 percent of the value of your investment may also be assessed when you sell a mutual fund shortly after buying it (usually within 30 to 180 days, depending on the fund). ETFs do not have loads or redemption fees.
Investors need to consider all the fees and charges and their time horizon when deciding on investments.
For instance, it may be better to pay a front-end load in exchange for a lower expense ratio when an investor has a time frame of 10 years or more, said Ilene Davis, a licensed financial consultant with Financial Independence Services in Cocoa, Florida. Funds that charge a front-end load generally have lower ongoing fees (and sometimes the absence of 12b-1 fees) than comparable funds that do not charge a load. Investors should always check and never assume anything.
Depending on the fund, mutual funds may have investment minimums of $1,000 to $3,000 or even $10,000, though these minimums are sometimes lower and may be waived altogether if you make automatic monthly contributions. ETFs usually require you to buy just a single share, which often costs $50 to $100.
Buying shares of a fund on your own, outside of an employer-sponsored retirement account, can typically be done by opening an account with a brokerage firm or fund company, transferring money from your bank account, deciding which funds you want to buy, then placing an order. Many investors seek advice from a financial professional about choosing the appropriate type of account (retirement or otherwise), fund selection, and any tax implications associated with the choices.
It usually takes one to three business days to settle a mutual fund trade, and the trade will take place after the end of the business day regardless of what time you place it. Unlike mutual funds, ETFs are traded on an exchange, like stocks. Because they are traded on an exchange, they can be bought and sold at any time throughout the trading session, and their price fluctuates throughout the day. ETF trades usually take three days to settle.
Most investment companies will allow you to make automatic monthly contributions from your bank account to your investment account and will also automatically invest your contributions in the funds of your choice. Setting up automatic investments is a good way to make sure that you are investing consistently regardless of market conditions, a strategy that most investing experts agree can help produce superior long-term returns for most investors compared with trying to time the market.
What are ETFs and mutual funds good for?
Both mutual funds and ETFs are popular with investors for several reasons.
Mutual funds and ETFs are the market equivalent of the proverbial “not putting all your eggs in one basket.” They are collections of investments, not single stocks or bonds, and so have potentially less risk than putting all your money in the fortunes of one company. (Learn more: Knowing what financial eggs are where)
Of course, there is still the risk of overall market performance. And while all mutual funds and ETFs are diversified because they all hold a basket of investments, they differ in their degree of diversification.
A mutual fund that invests in stocks from all different economic sectors, such as a large-cap stock fund, offers more diversification than a mutual fund that only invests in health care stocks, for example. Likewise, an ETF that invests in stocks from numerous countries provides greater diversification than a fund that holds only stocks from Switzerland.
The purpose of diversification is to hedge your bets. When one type of investment is performing poorly, another type is often performing well. Stocks tend to perform well when bonds do not, for example.
Mutual funds and ETFs allow people to invest in markets in ways that would otherwise be out of reach. For example, few people can afford to buy one share of every company in the S&P 500, but most people can afford to buy one share of an S&P 500 ETF.
Also, Pincus pointed out that ETFs and mutual funds are useful investment tools because instead of owning stock in one company, these funds enable investors to own shares in multiple similar companies at once. In this way, investors can put money into industries and sectors they are interested in, like biotechnology or forest products.
Mutual funds are overseen by financial institutions and professional money managers, which can marshal resources for research and oversight that are typically beyond the average investor. While such management is not a guarantee of success, it makes many investors feel more comfortable and confident that their investments are positioned to produce a better return than if they were making investment decisions alone.
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This article was originally published in March 2017. It has been updated.