Mutual funds and exchange-traded funds (ETFs) have gained in popularity among investors in recent years as a relatively easy and affordable way to build a diverse portfolio. In this guide, we will cover what a mutual fund and ETF are, the costs associated with owning a share of a fund and the benefits and risks of investing in a fund.
A mutual fund, sometimes referred to as an open-end investment company, pools money together from a large number of investors and uses that money to buy stocks, bonds and other securities. An investor can buy into a mutual fund by buying a share(s) of the fund. Each fund is run and operated by a specific mutual fund company, and each fund has different investment policies and objectives.
Mutual fund shares can only be purchased directly from the fund company or from a broker. They cannot be purchased from other investors or on markets, such as a stock exchange. Mutual fund shares are typically traded at the end of the trading day, when the net asset value (NAV), or the price of each share of the mutual fund, is calculated. This is because NAV cannot be calculated in real time, unlike the price of a stock where you can see a change in the price from hour to hour.
The NAV is the amount of money it costs to buy a single share of a mutual fund. It’s different from the price of a stock, because it is calculated using the assets, which are the investments that the fund holds, and liabilities, such as overhead costs or employee wages of the fund company itself:
- Net Asset Value = (Assets – Liabilities) ÷ Shares of Mutual Fund
For example, let’s say that Company A manages a mutual fund that has invested $200 million dollars from its investors in a variety of stocks and bonds. This $200 million investment would be considered Company A’s assets. Let’s also say that Company A needs to pay $20 million to its employees and for rent. This would be considered the company’s liabilities. If the company has issued 9 million shares, the price that you could purchase a share of this mutual fund would then be $20:
- NAV = ($200 million - $20 million) ÷ 9 million = $180 million ÷ 9 million = $20 per share
This may be a little tricky to understand at a first, but it’s important if you are considering getting a share of a mutual fund.
When buying a mutual fund, you will also be charged fees by the fund company. There are a few types of fees that you encounter when you purchase a mutual fund, and we’ve listed these fees below.
|Load Fee||This is a sales or commission charge, typically 1-6% of the transaction, for buying or selling a share of the mutual fund. This fee is used to pay the brokers who sell the mutual fund. Not all mutual funds charge load fees, and those that don’t are called no-load funds. A load charged when you buy a mutual fund is called a front-end load, and a load charged when you sell a share is called a back-end load. For example, if you decide to purchase $100 of a mutual fund with a front-end load of 5%, then you would pay $5 for the load and invest $95 in the fund.|
|Expense Fee||This is an ongoing fee, typically 0.10-2.00% of the portfolio, to cover the operating expenses of the mutual fund company. This is deducted from the value of the fund itself, so it does not show up as a charge to the investor.|
|12b-1 Fee||This is another ongoing fee to cover the cost of advertising the fund and creating the fund prospectus. Not all mutual funds charge 12b-1 fees. The 12b-1 fee is named after a rule from the Securities and Exchange Commission (SEC) that created the fee. The 12b-1 fee is limited to a maximum of 1% of the portfolio, and if it is charged, it is usually at least 0.25%.|
Mutual funds that charge loads have not historically shown performance above and beyond mutual funds with no loads. It’s always wise to minimize fees as they can eat into your returns: if you have the choice between two comparable mutual funds, one with a load and the other without a load, it’s usually preferable to choose the no-load fund provided the expense fee is reasonable.
In the table below, we looked at three comparable mutual funds with different expenses to see just how fees can impact your returns. Fund A is a no-load fund with an expense ratio of 0.25%, Fund B is a no-load fund with an expense ratio of 1.25% and Fund C is a front-end load fund with a load of 5% and an expense ratio of 1%. We assumed 10% growth every year and an initial investment of $15,000 with no additional investments.
|Timeline||Fund A||Fund B||Fund C|
As you can see, Fund A has the highest value every year because it also had the lowest fees of the funds. With both Fund B and Fund C, the investor loses out on over $16,000 in additional returns because of the fees. Outside of loads, expense fees and 12b-1 fees, you may also be charged transaction fees if you purchase a mutual fund through a brokerage.
Index funds are a type of mutual fund that use a specific investment style called passive investing. Index funds try to match the performance of a market index, like the S&P 500 or Dow Jones Industrial Average, by investing in the same securities that make up the index. Managers of index funds do not try to actively invest, meaning they do not select securities they think will beat the average return of the market. Very few fund managers and investors are able to consistently select securities that perform better than the market overall.
Since index funds are passively managed, they typically charge lower fees than other types of mutual funds. For example, Vanguard, one well-known issuer of index funds, has a variety of no-load index funds with expense fees of less than 0.20%. Index funds are not exclusive to stocks either; there are many index funds that track bonds, real estate investment trusts (REITs), commodities or other securities.
There are other types of mutual funds beyond index funds. Some funds focus on specific types of assets or a specific investing strategy. Below we have included the most common types of mutual funds an investor will see.
|Money Market Fund||Invests in money market instruments, such as Treasury Bills and certificates of deposits (CDs)|
|Equity/Stock Fund||Invests primarily in stock|
|Income Fund||Type of stock fund that invests in stocks that have consistently high dividends|
|Growth Fund||Type of stock fund that invests in stocks that have the potential to grow substantially|
|Sector Fund||Type of stock fund that invests in stocks in a particular industry sector, like financial services or health care|
|Bond Fund||Invests primarily in fixed-income assets, such as treasury bonds, corporate bonds or municipal bonds|
|International Fund||Invests in securities inside and outside of United States|
|Balanced Fund||Invests in both stocks and bonds and designed to be an investor's entire portfolio (target date funds are a type of balanced fund)|
|Asset Allocation/Flexible Funds||Invests in both stocks and bonds that fund manager thinks will do well|
|Index Funds||Invests in securities that make up market index to match performance of the index|
These types of mutual funds are not all mutually exclusive -- an index fund that only invests in bonds would also be considered a bond fund.
Mutual funds are popular with investors for several important reasons. They are an easy and relatively affordable way to build a diverse portfolio. By purchasing a share of a mutual fund, you are getting a small piece of tens or hundreds of different securities. It would be much more difficult and expensive to purchase individual shares in all of these investments. Diversification is also extremely important when you are investing as you never want to put all of your eggs in one basket.
Mutual funds are also run by professional fund managers, who research and purchase securities and have more knowledge of the markets than the average investor. Since you purchase your shares directly from the fund or through a brokerage, mutual funds are also pretty liquid, meaning that you can sell your shares for cash easily.
As with all investments, there are inherent risks when investing in a mutual fund. The most important risk, which is true of all investments, is that you may lose money. Unlike a checking account whose value is insured by the FDIC, there is no such insurance on investments. Due to the structure of a mutual fund, there is also uncertainty and a lack of control around the price of the shares and the components of the fund. The price of a share is calculated at the end of the day, unlike stock prices that are in real time. This means that when you put in an order to buy shares of a mutual fund, you do not know what the exact value is until the NAV is calculated at the end of the day.
Secondly, you, as an investor, do not have control over the specific securities that a mutual fund invests in. Finally, past performance of a fund does not guarantee future performance. Just because a fund did extremely well the year before does not mean the fund will perform similarly in the current year.
Exchange-traded funds (ETFs) are very similar to mutual funds as ETFs pool money from investors and then invest that money into other securities, such as stocks and bonds. However, investors cannot purchase shares of an ETF directly from the company that manages it, but they can purchase and sell shares throughout the day on market exchanges (like the name suggests) and from brokerages. Because ETFs can be traded like stocks, they have a market price, which changes throughout the day. This market price is not always equal to the NAV of the ETF.
The fees associated with ETFs are a little bit different from mutual funds. Unlike mutual funds, ETFs do not charge loads or 12b-1 fees. Like mutual funds, they do charge expense fees typically ranging from 0.10-2.00%. The expense fees for ETFs are typically lower than mutual funds; in fact, many ETFs have expense fees that are lower than 1%. This is because investors can purchase shares through a broker, meaning the fund company does not need to market itself directly to investors. Brokerages may also charge transaction fees for buying and selling ETFs; however, some brokerages also offer commission-free ETFs.
A majority of ETFs are index ETFs, sometimes also referred to as index funds, that follow the same investing strategy as index mutual funds. In fact, the first ETF, called Standard & Poor’s Depository Receipt or SPDR (even “spider” for short), was an index ETF that followed the S&P 500 index, which tracks the stocks of 500 companies. There are a few ETFs that are actively-managed, but they typically have higher expense fees on par with mutual funds. Like mutual funds, ETFs can specialize in a variety of assets, including stocks, bonds, currency and commodities.
|Index ETF||Invests in securities that make up market index to match performance of the index|
|Stock ETF||Invests primarily in stock|
|Bond ETF||Invests primarily in fixed-income assets, such as treasury bonds, corporate bonds or municipal bonds|
|Currency ETF||Invests primarily in foreign currencies|
|Commodity ETF||Invests primarily in commodities, such as gold or agricultural products|
|Actively Managed ETF||Invests in a variety of securities that the fund manager thinks will do well|
Like mutual funds, ETFs provide investors the opportunity to invest in a diverse portfolio, but at significantly lower costs. ETFs do not charge loads or 12b-1 fees and most have lower expense fees than comparable mutual funds. ETFs can also be traded throughout the day, unlike mutual funds. Because of this, ETFs have a tax advantage over mutual funds. If many investors decide to sell their shares of a mutual fund back to the fund company, the fund company may need to sell investments to pay the investors. The sale of these investments could trigger what is known as a capital gains tax. Shares of an ETF can be sold to another investor or on a market exchange, so the fund company would never need to sell investments to pay investors and would therefore avoid triggering a capital gains tax in that scenario.
Much of the risks associated with ETFs are the same as those associated with mutual fund, with one notable exception. Since ETFs are traded throughout the day, there is the possibility that the market price of an ETF is not equal to the net asset value of the ETF. A small discrepancy between these two prices means that the cost advantage of an ETF may be lost. If the market price of the ETF is greater than the net asset value, then it is similar to paying a load on a mutual fund or paying a higher expense ratio.
The easiest way to buy a mutual fund or ETF is through a broker. Since it’s important to minimize fees, you may want to consider brokers that offer no-transaction-fee mutual funds or commission-free ETFs that have low or no loads and/or low expenses. You can also purchase shares of a mutual fund directly from the fund itself, avoiding any transaction fees charged by a broker. Some brokerages also offer their own mutual funds and ETFs, for which they may charge no commissions. However, these funds may have higher expense ratios or loads than comparable funds from different companies.
You should also read over the prospectus for each mutual fund or ETF you are considering. The prospectus is a document each fund issues that describes the fund’s investment objectives and policies. The prospectus will also provide details of the risks inherent in investing in the fund and all costs associated with purchasing a share of the fund. It will also describe the fund’s investment advisor and portfolio manager.
You should also be thinking about what type of fund you want to invest in and how it will fit into your current portfolio. This includes understanding what the fund invests in, how diversified it is and what the investment strategy is. Some funds invest in a specific type of assets whereas others are diversified across a variety of assets. Some may also use an active investment approach as opposed to a passive one (index funds). Most of this information can be found in the fund's prospectus, but it's still up to you to make to decide whether the fund makes sense for your portfolio.