Like any occupation, we in financial services sometimes take for granted that clients understand all the industry terminology we use. But much like your occupation there are probably words used that someone outside that industry wouldn’t quite understand. Take for instance a Mutual Fund, has anyone ever explained to you what exactly this investment vehicle is and how it works? It seems fairly straight forward, you invest in them inside your retirement plans and hear the word quite often, but do you really know how it works? How about ETF’s (exchange traded funds)? There have been plenty of advertisements for these investing products over the years but do you have any idea of what they are and how they work?
In the effort of keeping this blog short and concise here is a quick high level primer on both of these commonly used investment tools:
What are they and how do they work?
Both Mutual Funds and ETF’s are investment products made up of a basket of underlying stocks. The idea since the origination of mutual funds over 80 years ago was that investors needed a simple way to invest in a diverse basket of stocks in one easy step. Another way to think about this is what if instead of selecting mutual funds in your 401k, you were required to pick the individual stocks on your own? Many investors have a hard enough time picking a mutual fund out of a selection of 20, what if you had to select amoung thousands of stocks?
So the Mutual Fund is basically an investment entity (or vehicle) that is run by a Fund Manager and his team and they do the stock selecting for you. Your only requirement is to select if you want a Large Cap, Mid Cap, Small Cap, International or Sector specific type mutual fund. You then purchase shares of the mutual fund and instantly have ownership of all the stock holdings within that fund. Mutual Funds can be passively managed and track indexes such as the S&P or actively managed by a fund manager who tries to outperform the index.
An ETF (exchange traded fund) is the cousin to the mutual fund. It operates much the same way in that it is made up of an underlying basket of stocks. The difference is that most ETF’s are passive in that they are designed to track a specific index and they trade during the normal market hours just like a stock. (all buys and sells of mutual funds are done at the market close each day) Just like with mutual funds your job as an investor is to determine which ETF to buy to gain exposure to a certain asset class (large cap, mid cap, small cap, international or sector stocks)
A couple of key takeaways:
- mutual funds and etf’s have risks just like investing in individual stocks. They are made up of stocks and will rise and fall based on the performance of the underlying holdings.
- bonds: it wasn’t mentioned above but both mutual funds and etf’s can invest in a basket of bonds: treasuries, corporates, high yield, international which you can mix in with your “stock” funds or “stock”etf’s to properly diversify your portfolio.
- investing in a mutual fund or etf will diversify you across a basket of stocks in a particular asset class (ie: large companies), but you still need to invest across several funds in different asset classes (small companies, international companies, etc) to be properly allocated.