The summary, up front: (like dessert before dinner)
They both allow you exposure to many different investment opportunities and therefor, diversity in your portfolio. An ETF tracks a basket of shares or an index, trades on the stock market and is purchased as all other shares are, typically via a broker and you pay your broker’s fee and the trade fee. A mutual fund is professionally managed, takes a large sum of money made up from many different investors and uses that money to buy into various different investments that make up the fund. Mutual funds are sold by a company or bank and the fee associated is a percentage of the returns that the fund makes. The fund does not actively trade, but both the daily value of a ETF and mutual fund share is calculated using NAV (net asset value).
More details, please: (disclaimer: get comfortable.)
Exchange-traded funds (ETFs) and mutual funds are investment tools that allow you to get a taste of many different investments by making just one purchase. When you buy an ETF or mutual fund, you give yourself a great deal of diversification in that the portfolio (the collection of securities: stocks, bonds and other assets), can be made up of many different types of investments so that if say there are auto-makers and agriculture stocks in the same portfolio and agriculture doesn’t do so well but auto-makers are killing it, then you are hedging your risk; you’re balanced. Diversification means that you are not taking on an aggressive amount of risk by putting all of your hard earned money into one single investment, it allows for balance.
They both also allow you to be involved in the more expensive and out-of-reach investment opportunities, like blue-chip stocks. (Blue chip stocks are the big guns of the stock market like IBM, Boeing, Apple, whose stock prices are often in the hundreds and whose market cap is in the billions. These companies are typically financially sound, well-established and offer consistent returns. Keep in mind too that when you purchase stocks, there is a minimum bid, so it’s not like you can go buy just one of Apple’s stocks, you gotta buy a bunch.)
What are the key differences?
ETFs: An ETF is a fund that trades on the stock exchange and is made up to represent a certain aspect of the market. Perhaps a fund tracks an index, like the S&P 500, which represents the overall market (the actual ETF that tracks the S&P 500 is one of the most popularly traded and trades under SPY), or perhaps the ETF represents an area of the market like small businesses, or the auto industry. The price of an ETF share, like all stocks, is made by the market, but generally follows the net-asset value (NAV), of the underlying assets (stuff the ETF is made up of).
NAV: The per-share dollar amount of the fund is based on the total value of all the securities in its portfolio, any liabilities (aka financial debt or obligations like salaries), the fund has and the number of fund shares outstanding.
ETFs are purchased just like any other stock, typically through a broker incurring the broker’s fee as well as the trade fee, or without the use of a broker at a discount brokerage where you purchase on your own and only pay the trade fee. It is important to note that as a shareholder of an ETF, you do not claim ownership to the underlying investments, these are owned indirectly.
Mutual Fund: A mutual fund is a professionally managed fund that allows investors, both retail clients (individual investors) and institutional clients (corporations), to invest in a diversified and actively managed portfolio of assets potentially including securities (stocks & bonds), cash, gold bars, money market instruments, and other types of investments. Actively managing a fund typically means that the fund manager will look at the allocation of each asset within the fund, say ratio of domestic securities to international securities to cash, and redistribute the allocations based on the goals of the fund; the stipulated allocation percentage as promised to investors (some funds are mandated to hold a certain percentage of each asset so as to act more conservatively or work towards higher returns), as well as market conditions. The money that is used to invest in these assets is made up of a pool of many smaller deposits from individual investors and groups.
A mutual fund is often considered a product because it is something that banks offer as one of their services. The bank creates the mutual fund and encourages its customers to invest in it, with one of their people managing the fund. When a financial advisor encourages you to invest in a mutual fund you must ask two things: how much are the fees (for example, an annual management fee might be 2.5% – that’s 2.5% of the overall value of the fund – but if you look at the average expected returns, say between 4% – 6% of the overall value of the fund, then that 2.5% management fee is half of the returns the fund made, and that is heavy), and how often the fund is rebalanced or reallocated (with a mutual fund it’s a safer bet for an investor if the manager has a long term plan rather than a short term plan to generate returns and a nice annual bonus for themselves). Before buying, you should also look at what is in the mutual fund and then look at the markets, because a fund manager is never going to actually tell you that the market is doing badly.
In my own experience, a financial advisor at my bank recently tried to sell me on a couple mutual funds. The first was a risky one with three years of positive returns averaging about 8%, and then two years with huge losses averaging 11%. He tried to give it a positive spin but I was thinking, ummm…… Really? Pass. I then asked him what was in the second fund, and get this, he didn’t know. He had to look it up and then read from his computer screen. Bro, what am I paying you for if it’s not to know what’s in the product you’re selling? If this happens to you, please know it is not a good sign. In this situation, I asked the advisor to email me the links to these recommended funds and said I would do my own research, thank you very much.
Finally, The Wall Street Journal says: “A fund’s past performance doesn’t necessarily indicate future success. Seek out a diverse family of funds that have shown steady growth.”
And here are 5 things the Financial Post wants you to know before buying a mutual fund.
Featured image of Wall Street taken by me, when I was in New York, April 2016.
