Rather than trying to pick individual stocks and bonds — a game with far more losers than winners — many people start investing through mutual funds or exchange traded funds (ETFs).
Mutual funds and ETFs are similar in that they both invest in a basket of underlying investments, in most cases concentrating on a single asset class. And there are mutual funds and ETFs that invest in just about every major asset class in the world, including domestic and international stocks and bonds, REITS, and commodities. There are also funds that combine asset classes, such as "balanced" funds whose portfolio consists of a mix of stocks and bonds.
As a result, they provide an opportunity to invest more widely than you could otherwise do by buying individual securities.
A mutual fund is formed when an investment company creates a group, or family, of mutual funds. Each fund has a specific objective, such as providing long-term growth, current income, or sometimes a combination of the two.
Once a fund is created, it sells shares to investors. You may be able to purchase shares online or by contacting a company representative. Fund companies have made it a lot easier to buy shares this way. You may also buy shares through sales people at banks and brokerage firms or by participating in an employer-sponsored retirement savings plan that includes the fund as one of its investment options.
Mutual funds also make it easy to invest. Initial minimum investments are relatively low and you can make additional investments of $50 or $100 on a regular basis—or any time you want. A mutual fund will also buy back any shares you want to sell based on the fund’s price at the close of the business day. The price is called the net asset value, or NAV. Regardless of profit or loss, it’s easy to liquidate your shares.
Each fund pools the money it raises from its shareholders to make its investments. The more shares the fund sells, the more money it has to build a broadly diversified portfolio—much larger and more diversified than you as an individual investor could afford. The varied portfolio of some mutual funds makes them less risky than buying individual stocks and bonds.
For example, a “total U.S. stock market” fund typically holds shares in the thousands of companies publicly traded on the major stock exchanges. Or, a stock fund might focus on one sector of the market—say, large-company stocks, as represented by the S&P 500 Index—or it might invest primarily in smaller companies it expects to grow rapidly.
International stock funds hold equities in non-U.S. companies, either by owning companies in developed markets such as Germany, Japan, and Australia, or in emerging markets like India and Brazil.
A bond fund might own a particular category of bond, such as municipal bonds, or a variety of corporate or government debt. “Total bond market” funds typically own all those types of debt.
Exchange Traded Funds
Exchange traded funds are a bit more turbocharged than mutual funds because you can trade them at any time the market is open. This feature is good for active trading of investments. Whether active trading is good for the typical investor is another question, since it requires close attention, and the cost of frequent trading can eat into your profits or increase your losses.
There are advantages to exchange traded funds. They allow you to diversify into different niches of the world markets, they’re relatively inexpensive to buy and own, and some companies allow you to trade ETFs without paying a commission. The structure of ETFs can also limit the distribution of taxable gains to shareholders.
ETFs combine several attractive attributes of mutual funds and stocks. Like an index mutual fund, an ETF holds a portfolio of underlying securities determined by an index to which the ETF is linked. For example, the ETF named SPDR S&P 500 holds all of the stocks in the S&P 500 Index. ETFs linked to indexes can make asset allocation easy and they provide transparency, which means that you always know what securities the ETF is holding.
If you’re seeking diversification, it’s usually preferable to invest in an ETF that tracks a broad market, such as the S&P 500 or the Russell 2000, an index of approximately 2,000 of the smallest stocks in the market, as measured by stock market value. However, ETFs that focus on a very narrow market—for example, a specific industry, country, or commodity, such as precious metals — may also play a role in an already well-diversified portfolio.
Like stocks, ETFs are traded on the exchange where they are listed throughout the day. That’s not the case with mutual funds, which change hands only once a day at the close of trading. Each ETF has a NAV, or net asset value, which is calculated each day based on the changing value of the bundle of securities it owns. However, an ETF’s market price, like the price of a stock, is determined by supply and demand and other market forces. The NAV of a mutual fund, on the other hand, is the same as its price before the commission, if any, is added.
Investments Cost, But Some a Lot Less Than Others
You can’t avoid fees altogether, but the fees on some types of funds are generally higher than the fees on other types. The fees on funds that invest in small companies tend to be higher than the fees of funds that invest in large, well-known companies. That’s because identifying appropriate small companies takes more time and research.
Similarly, the fees on international funds that invest in countries around the world tend to be higher than the fees on funds that invest exclusively in U.S. securities. However, it can be smart to own small-company and international funds to diversify your portfolio.
The biggest debate in mutual fund investing, however, is between actively managed mutual funds and passively managed, or index, funds.
Manager invests to outperform a specific benchmark index (e.g., S&P 500)
Fund invests to replicate performance of a specific benchmark index
Higher fees than index funds
Lower fees than actively managed funds
Over time, more consistent performance than individual actively managed funds
An actively managed fund tries to provide a stronger return than the benchmark index for the type of investments it makes. For example, a fund that invests in large-company stocks typically wants to outperform the S&P 500 Index. The fund’s manager and his or her team research companies, choose investments, and trade stocks to achieve high returns. That increases the fund’s costs, which are passed on to shareholders as fees.
An index fund invests to replicate the performance of the index it tracks, not to beat it. If the fund tracks the S&P 500, for instance, it owns the 500 stocks in that index. If a stock drops out of the S&P 500, the index fund drops that stock as well and buys whichever stock replaces it.
Similarly, if a fund simply tracks an index of small-company stocks represented by the Russell 2000, the fund drops and adds stocks as the underlying index changes.
An index fund, then, does not have to pay a manager to choose investments. And there are few trading costs because the portfolio changes only when the index changes. The result is much lower fees for the fund’s shareholders.
Index funds almost always provide stronger returns than actively managed funds over the long term, precisely because of their lower costs. The same is true of many ETFs, which tend to have lower fees than actively managed mutual funds, though you may pay a commission to buy or sell shares.
An actively managed fund might do significantly better than its benchmark in one or three or even five years, but it almost never does so consistently. One of the biggest traps investors fall into is picking an actively managed fund based on its recent track record of beating its index. Mutual funds that post stellar short-term returns rarely post such stellar returns over longer periods. In fact, funds that are the best performers one year usually fall from the top of the heap fairly quickly.
Since the performance of actively managed funds is inconsistent, investors should focus on the things that really matter to long-term performance—how much a fund charges in annual fees, transaction costs, and sales charges.
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