ETFs and Mutual Funds:
One of the most common ways people get exposure to the stock is usually not through owning individual stocks, but by owning shares in an ETF(Exchange-Traded Fund) or a Mutual fund. The reason this is the case is because a lot of company’s 401(K) plans put their clients money to work in these specific types of funds. They are able to get their clients diverse exposure to the market at a relatively low cost. So seeing as the majority of your retirement savings are in these types of funds I think it is really important to know what these funds actually are and the differences between them. By the end of this article you understand why people buy these funds and the distinct differences between the two.
What are they?
ETFs and Mutual Funds do have a fair bit in common so in this section I will give you a brief overview of everything that they share.
Collection of Assets
Mutual Funds and ETFs are both collections of assets. Specifically we are talking about either a collection of stocks or bonds depending on the fund. Most people who purchase these funds do so to add diversity to their investment portfolio. It can be quite expensive to build a truly diverse portfolio if all you are doing is buy individual stocks. For example to buy one share of Amazon stock it would cost around $1,700 or you could buy one share of the IVV (very popular S&P 500 ETF) for about $300. This would give you exposure to Amazon stock along with many other companies (499 to be exact) without having to have all the cash that is required to buy one full share of Amazon. The above example is the reason why the most popular ETFs and Mutual Funds are index funds. Index funds are funds that mimic market indexes, usually the S&P 500 Index. Investors are able to get the diversification of these indexes without the required capital that it would cost to buy that many individual shares of those company’s stock.
Passive vs Actively Managed
There are two two main types of funds; actively managed funds and passively managed funds. A passively managed fund will just mimic an index like the S&P 500 or the Russell 2000. An actively managed fund is one that is actively buying and selling stocks to try and surpass the returns of the broader market. Passively managed funds will usually be accompanied by low fees, while actively managed funds will generally have higher fees. When actively managed funds do well it is easy to forget the fees, however if these funds fail to make money or trail the returns of the market you will still get hit with these fees. Keep reading to see what I mean by fees.
The last thing these funds have in common is a yearly fee called an expense ratio. An expense ratio is a yearly fee that the fund charges its customer to cover (you guessed it) its expenses. This is usually expressed as a percentage. If the fund is passively managed it will generally be accompanied with a lower expense ratio, but if it is actively managed expect a larger expense ratio to be there as well.
Let’s say you have a $1,000 invested in a mutual fund on January 1st with an expense ratio of 1%. Now let’s say over the year the fund grows by 20%. Your initial $1,000 is now worth $1,200. But don’t forget about that expense ratio. This fund had an expense ratio of 1% so that means it will cost you $12 for this year. So the amount you will have earned this year is actually $188.
What is a reasonable expense ratio?
Vanguard 500 Index Fund — .04%
Fidelity 500 Index Fund — .015%
Fidelity OTC Portfolio — .88%
Morgan Stanley Inst Growth I — .59%
What is different?
How they are purchased
ETFs are purchased on exchanges meaning you are buying them directly from someone else. This means that the price of an ETF will change during the day based on supply and demand for that particular ETF. This also means that you can end up paying a premium or a discount on an ETF’s assets because of investor demand of that particular fund.
When you buy shares of a mutual fund you are buying these shares directly from the fund company. The price of the mutual fund changes at the end of the day and it reflects the fund’s Net Asset Value (NAV). Net Asset Value is the price of all the securities that a particular mutual fund holds. This means that the price of a mutual fund cannot be inflated because of investor demand like an ETF can.
The minimum investment with an ETF is pretty simple, it is the cost of the ETF itself.
The minimum investment depends on the mutual fund. Some funds have required minimum investments and others do not, it all depends on the fund. However, one nice thing that mutual funds do allow that ETFs do not is that you can buy partial shares in a mutual fund. So once you get above the investment minimum you can just buy a certain dollar amount of shares from the fund. This is what occurs in your 401(K) accounts every time you get a paycheck. When the market is up your contribution will be able to buy less shares, but when the market is down your contribution will be able to buy more shares.
The only fees you have to worry about with ETF is the expense ratio (talked about above) and the commission fee you pay when you purchase the fund. A lot of brokerage companies offer no commission fee trading on particular funds so that is something to look for when choosing a brokerage house.
Mutual Funds have the expense ratio like an ETF, but some not all have other fees that you have to watch out for. The first one to look out for is Loads. Depending on the type of mutual fund you get you can be charged a load. This is a commission that is charged either when you buy the fund (front-load) or when you sell the fund (back-end load). No-load funds are becoming more common as investors are becoming more aware of fees and increased competition for investment dollars from low-cost ETFs. The last one to be weary of is Distribution and Service Fees. This is a fee some funds have that they use to cover costs of selling shares, marketing shares and sometimes providing shareholder services.
I know that was a lot of information, but I think it is very important for people to understand these two investment vehicles. If you have a 401(K) through work more likely than not what you are investing in is a mutual fund or an ETF. I also think investing in mutual funds and ETFs offers any novice investor great diversification and market exposure that was not accessible years ago. Hopefully you like this article and were able to learn something. If you have any questions or comments on this article let me know at firstname.lastname@example.org