By Timothy Guilmette, Spring 2014 Student Intern
Young people and professionals, whether starting a job or receiving a promotion, often reach a point in their financial lives when they want to start investing. This process can be daunting and many new investors have no idea where to start. This post covers some basic information on mutual funds and exchange traded funds. Investors looking to invest in mutual funds or exchange traded funds should do their homework, evaluate the advantages and disadvantages of each, and carefully read the fund prospectus before investing.
There are several main types of mutual funds, including stock funds, bond funds, balanced funds, money market funds, and index funds. Each fund category invests differently based on its type. For example, stock funds invest primarily in stocks, bond funds in bonds, balanced funds invest in both stocks and bonds, and money market funds invest in extremely short-term investments. Index funds are nothing more than mutual funds with holdings that mirror a specific index, like the S&P 500 or an international index.
Exchange Traded Funds
Exchange traded funds (ETFs) share similar attributes to mutual funds, but have some key differences. According to Investor.gov:
“Like mutual funds, ETFs offer investors a way to pool their money in a fund that makes investments in stocks, bonds, or other assets and, in return, to receive an interest in that investment pool. Unlike mutual funds, however, ETF shares are traded on a national stock exchange and at market prices that may or may not be the same as the net asset value (“NAV”) of the shares, that is, the value of the ETF’s assets minus its liabilities divided by the number of shares outstanding.”
The SEC has prepared additional information about ETFs that you can access here.
Risks and Rewards
Mutual funds and ETFs are often viewed as less risky than individual stocks because they pool investor money and invest it across different securities within the fund’s investment range. In theory this reduces the impact of losses associated with any one security. For instance, Vanguard’s U.S. Value Fund (VUVLX) month-end holdings on 12/31/2013, included, among numerous others, stock in Exxon Mobil Corp., General Electric Co., and Wells Fargo & Co. If, hypothetically, General Electric’s stock price soared and Wells Fargo’s plummeted, the losses on Wells Fargo may potentially offset the General Electric gains, or at the very least, decrease the net gains. This type of diversification provides a strong incentive to choose mutual funds or ETFs over individual securities because losses in one industry or sector might be evened out by gains in others.
Although potentially less risky than stocks, there are some disadvantages with mutual funds. Mutual funds may have fees associated with the management of the fund, minimum investment amounts, or other restrictions that investors should carefully consider before investing. Investors looking to invest in a particular fund should read the fund’s prospectus, the document detailing investment strategy, risk profile, fees and history.
For mutual fund fees, FINRA’s Fund Analyzer tool gives investors the opportunity to research over 18,000 funds. The tool allows for a side by side comparison of up to three funds at once, highlighting the hypothetical impact of each funds’ fees over a period of time.
Both mutual funds and exchange traded funds offer benefits to an investor’s portfolio, but understanding the potential risks associated with either is critical to achieving one’s financial goals.