Mutual funds and ETFs are similar in that they both invest in a basket of underlying investments. 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.
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. This makes funds less risky than individual stocks and bonds.
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—called the net asset value, or NAV—at the close of the business day, so it’s easy to liquidate your shares.
Exchange Traded Funds (ETFs)
ETFs combine 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. And like stocks, ETFs are traded on the exchange where they are listed throughout the day.
ETFs offer several advantages. Specifically, ETFs:
Allow you to diversify into different investment niches
Make asset allocation easy
Are relatively inexpensive to buy and own
Provide transparency, so you always know what securities the ETF is holding
May be structured to limit the distribution of taxable gains to shareholders
The NAV for each ETF is calculated daily based on the changing value of the securities it owns. But its market price, like the price of a stock, is determined by supply and demand and other market forces
Target Date Funds
If you contribute to a retirement plan at work, you probably have the option of investing in a target date fund. Generally, you pick the fund pegged to your expected year of retirement. For example, if you expect to retire in 2040, you would select a 2040 target date fund.
Typically, these funds start with a portfolio mostly in stocks and then shift over time to increase the percentage of fixed income. This shift, in theory, makes the fund less risky as the target date approaches. The pace and timing of this reallocation is known as the fund’s glide path.
Remember, however, that target date funds pose the same risk as other mutual funds and they do not guarantee that you’ll have the money you’re anticipating for retirement. You should also check if the fund’s allocation of holdings is appropriate for your individual goals and risk tolerance.
Active vs. Passing Investing
A big debate in mutual fund investing is about the relative merits of actively managed mutual funds and passively managed, or index, funds.
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.
One of the traps investors fall into is picking an actively managed fund based on its recent track record. While an actively managed fund might do significantly better than its benchmark over one year or even several years, it almost never does so consistently.
Index Funds. 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, so it 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.