Mutual funds and ETFs are key tools in building an investment portfolio, but what are they, exactly?
A mutual fund is a pool of different investments (stocks, bonds, cash, etc.) that are chosen by mutual fund managers. When an individual investor puts money in a mutual fund, that money gets combined with all of the other investors’ money in the fund. The fund managers then use that money to invest in specific assets of their choosing.
Often, mutual funds provide the average investor with access to investments they may not have been able to get otherwise. Each mutual fund can have upwards of 3,000 different investments, although a few hundred is more common.
ETFs or Exchange Traded Funds work the same way as mutual funds except that they can be traded throughout the day like a stock, where mutual funds can only be traded at the end of the day based on the Net Asset Value (NAV). ETFs do not have investment minimums or sales loads (i.e. trading fees) that mutual funds typically have, depending on your broker. Often, you will see ETFs with lower expense ratios (i.e. operating fees) than mutual funds, as well. There are also some tax advantages to ETFs; I’m not going to get into that here, but if you want to read more in-depth, check out this article from Investopedia.
One of the biggest advantages of investing in ETFs over mutual funds is lower fees. “Expenses” are fees that cover things like operating expenses, fund managers’ salaries, and promotional fees. Sales loads (or commissions) are fees charged by brokers who trade the funds; these vary depending on which broker you’re using. I’ll talk more about what to look for in brokers in a future post.
Having an investment with lower fees can make a big difference over time, as even a small percentage fee (a fraction of 1%) can add up and reduce the growth of your portfolio. Here’s a specific example: Let’s take a mutual fund and an ETF that each track the same index, Schwab Total Stock Market Index Fund (SWTSX) and Schwab US Broad Market ETF (SCHB), both of which track the Dow Jones Index. If you check out those links, you will see “Expenses” listed for each to the right of the quoted price. The mutual fund expenses are listed as 0.09%, and the ETF expenses are 0.04%. Even though both track the same index, you pay more than double – an additional 0.05% – in expenses for the mutual fund.
While a fraction of a percent might not sound like a big deal, consider the power of compounding. As the value of your investment increases, so would the fees since they’re a percentage of your investment. Conversely, the less money you spend on fees, the more of your money gets reinvested to grow. FINRA has a neat tool you can use to compare funds and fees.
When you’re just starting out with investing, you may not have a big chunk of change to work with. With some mutual funds, that means you’re out of luck. You might have seen the “Min. Inv.” number when you were looking at the page for SWTSX. The minimum investment for that fund is $100 – not bad. Some funds can have minimums of thousands or tens of thousands of dollars, which makes it hard for the average investor to get a piece.
ETFs, on the other hand, do not have minimums. However, you do have to buy whole shares (fractional shares are generally not allowed), so you have to be able to afford one share at market price.
There are many more aspects of researching and investing in mutual funds and ETFs to understand, and I’ll get into more detail in future posts. If there are specific topics you’d like me to cover, please let me know in the comments below!
Please note: I am not a financial expert and speak to financial topics from my own personal experience. Please consult a financial professional before making any of your own personal financial decisions.