Investment Insights: Mutual Fund vs. ETF
January 5th, 2018 by Tanner WrisleyIf you have an investment account, there is a good chance that you have owned or considered owning a fund of some variety. Funds are a very useful investment vehicle for investors, but it is important to know how they function and when they should be utilized in your portfolio.
Diversification is a staple of constructing a good portfolio. Funds are one way to help investors achieve this. A fund takes capital from different investors and pools it together to purchase securities while allowing each investor to retain ownership of his or her own shares. With funds, investors can gain exposure to a broader investment selection and more management expertise at lower fees than attempting the same allocation on their own. There are many different types including mutual funds, exchange traded funds, hedge funds, money market funds, and more that all function differently. Hedge funds involve a large amounts of capital and risk and are only appropriate for investors who meet certain criteria. Money market funds are very short-term, low-risk, low-return investments that are often used as a cash substitute. However, mutual funds and exchange traded funds are most commonly used to construct a portfolio because of their characteristics.
Mutual funds (MFs) and exchange traded funds (ETFs) are similar in their characteristics and meeting many investor’s objectives. Both are a great way for investors to quickly diversify with any amount of capital. Say an individual would like to have investment exposure to many different areas of the market, but they only have $1,200 to invest. This person might be able to buy 1 share of Google, but now all of their capital is tied to the success of one asset class (Equity), one sector (technology), and one company (Google). The alternative is to invest in a fund that tracks a plethora of securities, thus spreading out their $1,200 over multiple asset classes, sectors, and companies if they so choose. Both Mutual Funds and ETFs are a useful to diversify without large amounts of capital.
However there are differences between these types of funds that are important to consider. Mutual funds are priced once at the end of the day and do not trade on an exchange. When an investor purchases a Mutual Fund during the trading day, that investor will not know what the fund is worth until it is priced later in the day. ETFs trade on an exchange throughout the day like stocks, giving them greater liquidity. ETFs also offer greater investment flexibility because unlike mutual funds, ETFs can be shorted, day-traded, and bought on margin. Also, ETFs were generally created to track indexes as opposed to being actively managed and often have lower expense ratios than Mutual Funds because of this.
Some employer sponsored retirement accounts, like 401Ks, only offer mutual funds for investment choices. However when available, more and more investors and wealth managers are looking to ETFs to help diversify their portfolios efficiently and with greater flexibility. Funds are a great way for investors with small to medium amounts of capital to achieve diversification faster, simpler, and in many cases, cheaper.