Investing Series: Mutual Funds and Exchange Traded Funds

Okay. We’ve talked about stocks and we’ve talked about bonds. I’ve mentioned before that I don’t recommend most people buy individual stocks unless they are willing to do a lot of research. So now let’s get into some different investment vehicles that I do recommend buying, shall we? And per reader request, I’m going to start with an explanation of mutual funds and exchange traded funds (ETFs), plus a comparison of the two.

What is a Mutual Fund?

Think of a mutual fund as a neighborhood tool shed. You’ve heard those, right? When everybody on the block pitches in some money to buy one snowblower, one lawn mower, etc? And then everybody shares them? A mutual fund is kind of like that.

A mutual fund is when many investors pool their money to build an investment portfolio. The portfolio might contain stocks, bonds, money markets accounts, or other investments. A money manager operates the mutual fund on behalf of the investors in accordance with the investment objectives of that particular mutual fund.

The investment objectives will be stated in the fund’s prospectus, which is a document that also lists the fund’s risk level, fees, expenses, and other information. Investment objectives are the goals of the fund. Possible objectives are short-term or long-term growth, stability, dividend returns, etc.

How does a Mutual Fund work?

A mutual fund allows smaller investors (you and me) to diversify their portfolios with the aid of professional management. By grouping money, investors are able to access investments we might not otherwise be able to purchase, such as those that are very expensive. Instead, we pay for shares of the mutual fund, aka the net asset value per share (NAVPS). The NAVPS is the value of all of the investments divided by the number of shares within the fund. It’s calculated once daily, after the price of the securities within the fund are finalized for the day.

In addition to the NAVPS price, each investor will also pay a fee, known as an expense ratio. An expense ratio is the cost of the management and administration of the fund, expressed as a percentage of the total value of the fund. The fees can be charged when the fund is purchased, when it is sold, or neither.

Why buy a Mutual Fund?

Because mutual funds gather a group of individual investors’ resources, they benefit from an economy of scale. This means the mutual fund can have lower trading costs than you, investing alone. It also allows for greater diversification because the money manager can buy a broad swath of securities instead of you being limited to just a few.

What do I mean by that? Well, imagine you had $1,000 to invest, and 200 different investment options all costing $100 each per share. You’d only be able to buy a total of 10 shares, right? Because $1,000 divided by $100 each is 10 shares. You could buy 10 shares of the same company, or 1 share each of ten companies, but you’d never be able to buy more than ten shares with your $1,000. You can be a little diversified, but not very.

Now imagine that 20 people each contribute $1,000 to a mutual fund. The fund now has $20,000 to spend. Now the money manager can buy one share of each of the 200 companies. Or maybe she will buy 10 shares each of 5 of the companies because they are really quality, and 1-4 shares each of some of the other companies. Now you can really start to diversify! You, as one of the 20 investors, would only own 1/20th of the total investments, but you can own a broader swath of securities.

And of course, as the size of the investor pool goes up, you can diversify more and more while also enjoying lower individual costs. You see, it’s going to cost the manager relatively the same amount to run the fund whether there are 20 investors or 200. So your expense ratio can be significantly lowered if the mutual fund includes a lot of investors.

What is an Exchange Traded Fund (ETF)?

An ETF is an investment vehicle that tracks an index, commodity, bonds, or a group of assets like an index fund. This makes it a passively managed investment option. Like a mutual fund, it includes a variety of securities within the fund. Unlike a mutual fund, ETFs are traded on the market as if they were a single stock, hence the name. This means the price of the ETF changes throughout the day.

How Does An ETF Work?

As an investor, you don’t directly own the assets within the ETF. Instead, you indirectly own shares of portfolios that own the assets. I understand if that’s a little confusing – it confused me at first too. Think of it like this. Say there was a private library, and you could invest in that library. Your share of the library is like the ETF, the library itself is like an index which tracks popular books, and the books are the actual stocks and bonds. You directly own a portion of the library (the index) and indirectly own the books (the assets). Get it?

You might be wondering what the heck an index is, then, and why you wouldn’t just own an index fund instead of an ETF. Fantastic question! That will be next week’s post. Teaser: simplicity vs flexibility.

Why Buy an ETF?

An ETF allows similar diversification to what you’d get with a mutual fund, but with some added benefits.

First, the fact that the ETF is traded on the market like a stock means you have more flexibility. Like I said, we’ll discuss that more next week. But for now, just know that ETFs are typically a more flexible investment option.

You might also save money with an ETF. ETFs tend to come with significantly lower costs than mutual funds as a result of being passively managed. For instance, you might find an ETF with an expense ratio of .2%, while a mutual fund might have an expense ratio of 1% or higher. ETFs are also more tax-efficient than mutual funds, due to how ETFs are set up legally.

This probably requires a blog post all on its own. Basically, in a mutual fund sales of assets can result in capital gains (earnings), which result in capital gains taxes. ETFs use “in-kind redemptions” instead, which are less likely to result in capital gains. Yeah, that probably deserves its own post…

Comparing Mutual Funds and Exchange Traded Funds

Mutual funds are actively managed by that money manager I mentioned, while exchange traded funds are considered passively managed. Which one you consider better is really a matter of personal opinion. Actively managed funds aim to beat the market, while ETFs aim to match an index of part of the market.

If you are a fan of actively managed funds, a mutual fund is probably a good choice for you. You get the professional service of a manager, with the added benefit of diversification that you can’t achieve by purchasing individual stocks. If you believe brokers are likely to beat the market then you may do better with a mutual fund than picking your investments yourself. If you believe that passive management is the way to go and that brokers aren’t very good at predicting the market, ETFs are probably the better choice.

You should also consider costs when choosing your investments. Conventional wisdom says that all things being equal, you should go with the lower fees. ETFs typically cost less than mutual funds. Investing in the mutual fund would only make financial sense if you expect it to earn a high enough return to make up for the higher fees. Sometimes they do, sometimes they don’t.

The flexibility differences in mutual funds and exchange traded funds is also a consideration. You are limited in your ability to buy or sell shares based on the price because mutual funds only change their price once daily, at the end of the day. You simply don’t know, and would only be able to figure it out if you tracked all of the assets within the fund. With an ETF, you can track the price throughout the day and react accordingly. Of course, that’s not my style. I’m a buy and hold investor and wouldn’t react to market changes that quickly. But if you are a trader, this is an option.

Gentle reminder: I am not a personal finance professional. You should always do your own research before making changes to your finances and talk to a professional if you need additional help. Please read my full disclaimer here.

Do you invest in mutual funds and exchange traded funds? Which do you prefer?