10 Fundamental Things You Must Know About Mutual Funds and ETFs
Investing is an essential part of building a retirement and saving for the future. Entrusting all your investment decisions to a financial advisor could leave you paying higher fees than necessary and limiting returns. It is not necessary to master every aspect of investing before beginning. Understanding the fundamentals and a few basic principles can lead to wiser investment decisions that match long-term goals.
Mutual funds and ETFs are a convenient method for increasing diversification and managing risk. They are effective for both small and large investors and can accommodate automatic investing strategies while reinvesting gains for greater earning potential.
Here are 10 Investment basics for Mutual Funds and ETFS that you must know:
- How Are Mutual Funds and ETFs Similar? Mutual funds and ETFs are a conglomerate of stocks and/or bonds with specific investment objectives. Instead of buying a single stock, mutual funds are buying 100 or even 1000 stocks in a single fund. The advantage of this strategy is you spread your risk across multiple companies and industries simultaneously. This strategy will build a diversified portfolio with fewer dollars, potentially leading to higher returns at a lower risk.
- How Are Mutual Funds and ETFs Different? Mutual funds and ETFs are both a conglomerate of companies which you buy and sell A mutual fund is an open-ended fund that issues new shares and closes out shares when you buy or sell into the fund. You pay or receive a set price established at the end of each day (4 PM) called NAV (Net Asset Value). Everyone who purchases or sells that day pays or receives the same price for the fund. ETFs trade like stocks with the price fluctuating throughout the day.
- Actively Traded Funds Versus Index Funds? Funds come in these two varieties. Index funds do hire an active fund manager and are designed to mirror a specific index like the S&P 500. They carry the same ratio of stocks and bonds in the same industries as the index they track. Actual Fund holdings will vary. Index funds typically charge lower fees than actively managed funds that must pay a fund manager to select stocks and bonds based on market conditions.
- Diversification is a central key to investing success. Historically different categories of stocks and bonds do well under different market conditions, which builds the case for diversification. You can build a portfolio that includes different size companies in different industries for a more stable portfolio. Doing so will take advantage of market runs while reducing overall risk. For example, owning one tech stock is much riskier than owning a dozen. Having money only in tech stocks is much riskier than having money in tech, financials, and consumer goods. Funds allow you to accomplish this seamlessly.
- Pay Attention to Fund Expenses. There are three basic kinds of fees. The fees the fund charges (expense ratio), the cost to get in and out of the fund (sales charge), and account fees. Fund fees cover the cost of the fund manager, marketing, and operating costs of the fund. These fees vary widely among funds and impact returns. Sales charges are usually seen with ETFs in the form of commissions and mutual funds in the form of a load fee, based on the share class you purchase. Banks and brokerage houses charge account fees annually based on balances held.
- How Much will it Cost to Buy? The benefits of funds are that even small investors can get in the game. It does not take a lot of money to open an account with many companies accepting automatic contributions as low as $50 a month. 401Ks offer mutual funds and contributions are a percentage of your income. Paying money to invest will reduce the amount of money available to grow in the account.
Mutual funds come in share classes with the most common being A, B, or C shares. Shares charge the highest load up front but have the lowest expense ratio. Long-term investors who want to be loyal to a particular fund family will see the lowest overall cost with A Shares. Discounts on the load are available for larger buys. B Shares have no up front costs, so your entire investment goes to work immediately, but they charge a higher expense ratio. There is also a declining fee if you sell within the first several years of ownership, called a back end load. Once the redemption period expires the shares convert to A Shares, with the lower expense ratio. C shares have a small fee in the front fee accompanied by a higher expense ratio, and never convert to the lower cost A Shares. C Shares are best for shorter term needs. ETFs pay a commission at the time of the buy and sometimes at the time of a sale, which is a fixed transaction fee. The larger the buy, the lower the significance of the fee.
- Past Performance is NOT an Indication of Future Performance. We all want to buy low and sell high, but the truth is that most individual investors do the opposite. You see a fund that has performed great over the last couple years and jump in at the top of the market. Then when market adjustments occur you sell out because you are afraid you picked the wrong fund. You cannot time the market because factors which move the market are completely out of your control. A crisis in another country can send the markets all over the place. Choose funds based on their costs, your risk tolerance, and your diversification needs and then stay the course.
- Keep a Long Term Perspective. Investing is not about reaching your goal in 6 months. It’s not about the quarterly report that just came out, even though these report may immediately impact the fund price. Choosing a long-term outlook that will allow you to weather the market storms that come around every few years. As a whole the market trends in an upwardly direction. However, the day to day stocks and bonds will go up and down based on immediate market conditions. Those who jump in and out of funds almost always fare worse than those who stay invested.
- Dividends and Capital Gains are the two ways to make money in mutual funds. Capital gains are the rise in price that occurs as fund performance and market conditions lift the individual stocks or bonds within the fund, increasing its overall value. Dividends paid by some stocks result in additional gains. Both result in more money in your pocket. More conservative stocks are more likely to pay dividends while more aggressive stocks are more likely to have strong capital gains.
- Mutual funds are not tax advantaged accounts. When investors sell out of the fund the manager may sell out of stocks or bonds at inopportune times, leading to higher taxes. ETFs are more tax efficient because the funds buy and sell existing shares, instead of issuing new shares when investors buy. In retirement accounts, tax efficiency is not as significant, as in traditional brokerage accounts.