Mutual Funds and ETFs: Decoding the Investment Mysteries

Mutual Funds and ETFs: Decoding the Investment Mysteries
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The Very Large Number of Investment Choices

For investors, the biggest decision is often deciding in which investments to invest. There are tens of thousands of different stocks and bonds trading in their respective markets. Mutual funds and exchange-traded funds—ETFs—give investors the option to buy investments, which are participation in a portfolio of stocks, bonds or a combination.

Inside the world of mutual funds and ETFs, there are again thousands of choices. An investor can narrow down his or her choices with an understanding of how these fund types work, the different features they offer, and the differences between mutual funds and ETFs.

One point to remember is that most exchange-traded funds are organized under the same rules that govern mutual funds. The primary differentiation is how the shares of the two fund types are bought and sold. Included in our discussion here are links to specific articles with further, in-depth discussion of the different topics.

Fund Types

The two basic types of mutual funds are stock funds and bond funds. A fund is a portfolio of the selected type of securities and investors own shares of a fund representing a portion of the portfolio. All earnings—dividend, interest or capital gains—are passed through to investors. Funds referred to as balanced, asset allocation, or life style funds hold both stocks and bonds.

The ETF world also has stock and bond funds. ETFs are available to invest in a wider range of asset classes such as commodities, precious metals, and energy values. Although both mutual funds and ETFs can be either broad-based or focused on a specific sector of the market, ETFs are the more popular choice for investing or trading specific sectors.

Buying, Investing and Selling

The defining difference between mutual funds and ETFs is how they are bought and sold. Mutual fund shares are purchased directly from the fund company and redeemed with the fund company. Even if you invest in a mutual fund through a brokerage account, the buying and selling transactions still go through the fund company. Share prices for mutual funds are set once a day after the markets close. All buy and sell orders placed during the day are then filled at that price.

Exchange traded fund shares trade on the stock exchanges like shares of individual stocks. Shares of an ETF are formed when a large institutional investment company trades a batch of individual securities to the ETF sponsor for shares of the fund – usually in 50,000 share blocks. The shares then go into the market and they trade without any involvement of the issuing fund company. The share price of an ETF will fluctuate during the day to reflect market conditions and the value changes of the securities held by the fund.

ETFs are often used as part of an investing or trading strategy.

Active vs. Passive Portfolio Management

A mutual fund may be run as an actively managed portfolio or as an index fund. Actively managed funds have professional money managers who buy and sell stocks or bonds to meet a fund’s investment objectives and hopefully, outperform the overall market. Index mutual funds buy securities to match the stocks or bonds tracked by a specific index, such as holding the 500 stocks in the S&P 500 stock index.

Index funds function under the philosophy that an actively managed portfolio has a very low chance of beating the market over the long run and investors will do better in an index fund with lower management expenses.

All ETF funds are index type funds. Active management is not allowed in an individual index fund. A fundamental of the share price valuation of ETFs is the market knows at all times the value of the securities held by a fund. This can only happen if the fund tracks an index or holds a single value asset such as gold bullion.

Commissions, Fees and Other Costs

Exchange traded fund shares are bought and sold through a stock brokerage account; many investors use an online discount broker account. Each time shares are bought or sold, the investor pays a stock trading commission. ETF shares trade just like stocks and the costs are the same. As funds, ETFs also have internal expenses, which show up in a fund’s expense ratio. These funds typically have relatively low expenses of 0.15 to 0.40 percent.

The first fee breakdown in mutual funds is between load funds and no-load funds. Investment advisers sell load funds and the shares have built-in commission charges—called loads—to compensate the brokers. No load funds do not charge any commissions, but investors must do their own research and due diligence into no-load funds.

The expense ratios of mutual funds also vary significantly. Actively managed funds typically have significantly higher expenses, with stock funds averaging about one percent in expenses. Expense ratios can go up to 2 percent or more. Index mutual funds usually have the lowest expenses of all funds, including ETFs. These funds compete on their low expense ratios, so investors can compare funds to get the best deal on fund tracking a specific stock index.