Investing Primer: mutual funds and ETFs

This is the fourth post in my investing series.  You can find my other posts on investing here:

Part 1: save, save, save
Part 2: stocks and bonds
Part 3: risk, asset allocation, diversification

Today I will be talking about mutual funds and exchange traded funds (ETFs). 

Vanguard Total Stock Market Index Fund (VTSMX)

Mutual Funds
Mutual funds pool money from many investors to buy securities, which can be stocks, bonds, real estate, and other investments.  When you buy a share of a mutual fund, you actually own a small fractional component of the underlying pool of securities within the fund.  Each mutual fund has a fund manager who chooses which stocks or bonds to purchase. 

You must purchase a mutual fund during a market trading day between trading hours.  The New York stock exchange runs Monday through Friday 9:30am to 4:00pm ET and observes most major holidays.  When you purchase a mutual fund, your order does not get fulfilled until the end of the trading day.  This is because stocks and bonds can be bought and sold throughout the day with continuously changing prices.  The net asset value (NAV), or price of the mutual fund, is not determined until after the market trading day closes.  The NAV is the average price per share of all the stocks or bonds within the fund. 

Advantages of Mutual Funds:

Simple Diversification

There are high costs involved in purchasing a diversified individual stock and bond portfolio.  These costs are ridiculously expensive and prohibitive for most investors.  Since each stock or bond mutual fund invests in a large number of stocks, bonds, or both, you get instant diversification when you buy a mutual fund share.  If you own one stock and the company collapses, you lose everything.  When you own thousands of stocks, the winners balance out the losers.

No commissions
You can buy the mutual funds directly from the mutual fund company without having to use a broker or advisor. A load is basically a commission paid to agents, advisors, or brokers who sell you a fund.  If you have a financial advisor, you likely have funds that have loads.  Loads can be applied on the front end (A shares), back end (B shares), or ongoing (C shares). No matter how they’re called, all load funds charge a commission on the money you invest.  When you invest through an agent or advisor, you’re making him or her richer, whether or not your funds are successful. 

Liquidity
Open-end mutual funds can be redeemed for the current net asset value (NAV) any day the market is open to trading.

Automatic reinvestment
Dividends and capital gains can be automatically reinvested in the fund.

Variety
There are many different types of funds available, and you should be able to find a fund to fit just about any investment need that you may have.  REIT, Dividend growth, domestic, international, etc etc.

Funds of Funds
To make things really simple, you can purchase a single mutual fund that meets your desired asset allocation of stocks, bonds, or both.  There are lifecycle or retirement funds that automatically become more conservative as time goes by.  You just choose the fund that satisfies your present desired asset allocation.  With lifecycle funds, the percentage of stocks decrease and the percentage of bonds increase with time.  One downside of owning these kinds of bundled funds is that they cost slightly more than building a portfolio yourself.  Also, you may not agree with the preset asset allocation. 

There are 2 major types of mutual fund management styles: active management and indexing.  Active investment managers attempt to pick the stocks and bonds they hope will result in their fund outperforming their benchmark.  Active mutual funds tend to be more expensive and have not proven over time to beat an index fund that simply tracks the market. 

With indexing, the fund attempts to copy as close as possible the return of the benchmark it chooses, such as the S&P 500.  The index fund manager attempts to hold individual stocks and bonds in proportion to the weight of stocks or bonds in the benchmark. 

Over long periods of time, multiple studies have concluded that very few managers consistently outperform simple index funds, given the higher costs associated with actively managed funds.  Stick with the simplicity of index funds and you will be rewarded with fewer fees, better results, and more money.

Exchange Traded Funds (ETFs)

These are basically mutual funds that trade like stocks on an exchange.  Like mutual funds, most ETFs track some type of index, like domestic or foreign stocks and bonds.  Unlike mutual funds, ETFs are priced continuously throughout the day.  They can be bought and sold any time the stock market is open for trading.  When you purchase an ETF you know exactly the price that you are paying for the trade.  With mutual funds, you buy shares before the end of the trading day, and know the price you paid only after the fund calculates it's net asset value (NAV).  

The biggest benefit of owning an ETF is the low cost, which can be even lower than many mutual funds that track the same index.  This is great for investors who have a large lump sum to invest.

Another big difference with ETFs is that you cannot purchase fractional shares of an ETF like you can with a mutual fund.  With a mutual fund, you can contribute any dollar amount and you will  get as many shares within the dollar amount as possible, including fractional value for your money.

For example:

One of the index funds I own is the Vanguard Total Stock Market, VTSMX.  Yesterday, each share closed at a value of $40.77.  If I were to deposit $200 into VTSMX, I would own 4.9056 shares ($200 / $40.77 = 4.9056)

With an ETF you can only buy individual shares, and need to link a money market account to make a purchase. 

The ETF version of the Vanguard Total Stock Market is VTI  Yesterday, each share of VTI closed at a value of $83.79.  If I were to deposit $200 into VTI, I could only purchase 2 shares ($83.79 x 2 = $166.98).  I would not be allowed to purchase a fractional share of this ETF like I could with an index fund.

Given the choice between investing in a mutual fund or an ETF, I prefer the simplicity of mutual funds.  Most professionals would agree that low-cost index funds should be the primary investment choice of most investors. 

That’s it for today. 

In the next post, I will discuss the importance of minimizing costs.  Are you starting to get excited about investing yet?!