Mutual Funds and ETF’s – The Basics

Written by: Scott Sery

Most people know of stocks, and when we talk about investing we usually refer to the stock market.  This is just a small portion of the investment world, and most people will never even directly own stocks, instead preferring to stick with the less volatile mutual funds and ETF’s.

When an investor hears the term “individual issues” they should immediately think “stocks and bonds.”  Stocks are shares of a company, so when we talked about owning a portion of the company, each share of stock represents a fraction of the company.  Companies that are publicly traded (that is, they have issued shares of stock) have a set number of shares available on the market.  These shares are traded back and forth between individual investors, and investment companies.  The value, or price, of the stock can increase not only when the company profits, but also when the demand for the stock goes up.

On the other side of the coin are bonds.  Bonds represent a debt owed by the company.  In essence when a person buys bonds, they are lending money to the company, the company will pay them a set interest each year, and repay the entire bond at the end of the specified term.  Most people will never invest directly into stocks and bonds.  The investments individually hold more risk, and are more volatile than mutual funds.

The majority of investments are done through mutual funds.  There are several hundred mutual fund families each offering anywhere from one fund to several dozen funds.  Mutual funds are so popular amongst investors because of how they are structured; with any one mutual fund maintaining several hundred underlying stocks and bonds in it.  The theory behind it is that if one company has poor performance, the entire mutual fund should not lose much value.  By reducing volatility the mutual fund will provide the investor with investments that are not as sporadic and hopefully provide returns that are better than the indices.  Mutual funds can range from 100% equities (stocks) to 100% fixed income (bonds).  Because the underlying stock prices are constantly changing, mutual funds are only priced once at the end of the trading day.  The fund families are constantly buying and selling the underlying holdings, and mutual funds must charge an upfront sales charge to buy into them that is as much as 5.75% as well as charging an annual fee ranging from .1% to 2%.  The more expensive funds hope to outperform the market by at least what they charge in fees through active management.  By employing managers to study the market and move money between individual issues, these funds hope to gain a better return than their cheaper competitors.

ETF’s, or Exchange Traded Funds, have become almost as popular as mutual funds over the last several years.  These funds are structured much like a mutual fund, in that they have a number of underlying holdings, but they are constantly priced throughout the trading day.  In theory a person could purchase an ETF in the morning, and sell in the afternoon when they see the value increase.  ETF’s skip the 5.75% up front sales charge and instead the investor pays the commission set by their broker.  ETF’s still charge an annual fee, however many are un-managed so the fees tend to be on the lower end of the range.

Knowing what types of investments out there is only half the battle.  Together, mutual funds and ETF’s offer a range of investments that will meet the needs of almost every investor.  But once a person understands where their money will be invested, and what it will do once it is there, then they can choose how to invest.


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Mutual Funds and ETF’s – The Basics

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