Understanding Mutual Funds, Index Funds, and ETFs
It’s common knowledge that investing in mutual funds, index funds, or exchange-traded funds (ETFs) can help build a diversified portfolio. These funds hold diverse baskets of securities, including stocks, bonds and other assets from real estate to derivatives. By investing your money in a variety of investments, you help minimize the risk that your investments will lose value all at once, and you broaden your opportunity for gains.
But how do you choose between these options? Each type of fund has its own advantages and drawbacks, and with planning you and your financial advisor can work to determine which is best for you.
What are mutual funds?
A mutual fund pools money from many investors and uses it to invest in a variety of securities. Mutual fund shares represent partial ownership of the fund and entitle investors to the income generated by that portion. These funds tend to have minimum investment amounts between $500 and $5,000.
Mutual funds are usually actively managed. Experienced professionals select and monitor the securities held in the fund, with the aim of maximizing return while ensuring their selections meet the goals laid out in the mutual fund’s prospectus. Active management can make mutual funds a relatively expensive choice compared to other fund options. Compare fund expenses by looking at a fund’s expense ratio, which compares total fund costs to total fund assets. The lower this percentage, the cheaper the fund is to own. On the other hand, higher expenses can eat into your long-term returns.
Unlike stocks, which trade throughout the day, mutual funds only trade once per day after the market closes. Prices are based on a fund’s current net asset value (NAV), calculated by adding the total value of the fund’s holdings and subtracting its liabilities.
In addition to stock and bond funds, money market and target-date funds (TDFs) are other common mutual fund options. Money market funds invest in short-term debt. They’re designed to provide higher returns than interest-bearing bank accounts, and are used by individuals and institutional investors to invest in shares of government bonds, corporate stock, bank debt, and more. TDFs are popular retirement investment vehicles. Individuals select a TDF with a particular a target date, such as the year they wish to retire, and the fund gradually shifts to a more conservative asset allocation as that date approaches.
What are ETFs?
ETFs differ from mutual funds largely in the way investors purchase them. They are traded on the stock market throughout the day just like stocks, making them a more liquid option than mutual funds. There are no minimum investment amounts, and some brokers even allow you to buy fractional shares.
ETFs are usually passively managed, built to track a broad market benchmark. Passive management doesn’t require daily human touch, which often makes them a cheaper option than mutual funds. That said, some actively managed ETFs do exist, often with the goal to outperform a benchmark. Investors will likely pay more for active funds.
What are index funds?
An index fund can be a mutual fund or an ETF, but they are passively managed and built to track a market index, such as the S&P 500 or Russell 2000, for instance. Depending on the design of the index fund it may track all or a portion of the securities in a given index. As mentioned above, passively managed funds tend to be cheaper than active alternatives.
Contact us today to discuss your short- and long-term investment goals and we can help guide you toward the investment tools that are right for you.
Every type of investment, including mutual funds, involves risk. Risk refers to the possibility that you will lose money (both principal and any earnings) or fail to make money on an investment. Changing market conditions can create fluctuations in the value of a mutual fund investment. In addition, there are fees and expenses associated with investing in mutual funds that do not usually occur when purchasing individual securities directly.
ETF shareholders should be aware that the general level of stock or bond prices may decline, thus affecting the value of an exchange-traded fund. Although exchange-traded funds are designed to provide investment results that generally correspond to the price and yield performance of their respective underlying indexes, the funds may not be able to exactly replicate the performance of the indexes because of fund expenses and other factors.
Any opinions are those of Oechsli Institute and not necessarily those of RJFS or Raymond James. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. Investing involves risk and you may incur a profit or loss regardless of strategy selected, including diversification and asset allocation. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Material prepared by Oechsli Institute, an independent third‐party.
Sources
https://www.sec.gov/investor/pubs/sec-guide-to-mutual-funds.pdf
https://www.cnbc.com/select/what-are-index-funds/
https://www.cnbc.com/select/what-are-etfs-should-you-invest/
https://www.investopedia.com/articles/exchangetradedfunds/12/brief-history-exchange-traded-funds.asp
