A few months ago, we started a new series of articles called “BACK TO BASICS.” In each article, we examine one of the basics of financial planning and investing. In this article, we’ll look at:
Back to Basics #3:
While it’s possible to invest in individual stocks, bonds, and other securities, many investors prefer to use investment funds.
An investment fund is when a group of investors pool their money together to collectively invest in a certain way. This makes it simple and easy for individuals to invest in a wide range of securities at the same time. There are several types of investment funds, and as you can imagine, each comes with different pros and cons.
Funds are very popular, but in our experience, most people don’t know how they work or which type is right for them. We can’t answer that second question here, of course, but we can at least give you a breakdown on how some of the main types work.
Quick disclaimer before we go any further: Every type of investment comes with risk. And nothing you’re about to read should be taken as an endorsement or a recommendation. We don’t do that sort of thing in an article.
Okay, ready? Let’s start with:
Here’s how the Securities and Exchange Commission (SEC) defines mutual funds:
A mutual fund is a company that pools money from many investors and invests the money in securities such as stocks, bonds, and short-term debt. The combined holdings of the mutual fund are known as its portfolio. Investors buy shares in mutual funds. Each share represents an investor’s part ownership in the fund and the income it generates.1
There are two main types of mutual funds: actively-managed, and passively-managed. More on the latter in a moment. An actively-managed mutual fund means the fund employs one or more managers to perform investment research, select the individual investments in the fund, and monitor performance.
Many investors flock to mutual funds because they offer several potential benefits:
- The possibility of “outperforming” the market. If a manager picks the right investments at the right time, it’s possible the fund could bring a higher return than the overall market.
- Diversification. Mutual funds often invest in a wide range of companies and industries in order to lower your overall risk. This means that if one company or industry does poorly, you may not experience the same kind of loss that you would if all your money was invested in that company or industry.
There are potential issues with mutual funds, though. Statistically, most funds do not outperform the market – or at least not for very long. Mutual funds often come with more expenses than other funds, too, including management fees. These expenses can eat into your returns, thereby lowering your overall profit. For this reason, some people prefer to invest in:
Remember how we said there were two types of mutual funds, active and passive? Passive means the fund does not have a manager actively choosing investments. Instead, the fund tracks a specific index, like the S&P 500.
Understand, it’s not possible to invest in an actual index. What an index fund does is invest in the same companies that make up a particular index. Some funds will invest in all the companies in an index, while others will rely on a “representative sample.”
With an index fund, you’re essentially tying your fortunes to what the target index does. If the index goes up, so does the fund – and vice versa. The downside is that this makes investors particularly vulnerable to overall market volatility. During a bear market, for example, an index fund could suffer heavily. The upside is that the markets generally go up over the long-term. Another benefit? Index funds often have far lower expenses than mutual funds and “more favorable income tax consequences.”2
ETFs, as they are often called, can be similar to either mutual funds or index funds. Some ETFs are actively managed; most, however, track the companies in a specific index.
But ETFs differ from other types of funds in a few key ways. For one thing, the shares each investor has in an ETF can be traded on the open market. That means you can buy or sell your shares in an ETF just like you would an individual stock. You can’t do that with regular mutual- or index funds. That’s a big advantage for investors who value flexibility and liquidity.
Most ETFs also come with lower expenses than mutual funds.
But of course, nothing’s perfect. While ETFs can be traded like common stock, if you trade too often, you may find yourself paying more than you anticipated in trading fees. Then, too, some ETFs are thinly traded, meaning there’s just not a lot of activity between buyers and sellers. This can make it difficult to sell your shares.
There is a lot more information we could share on each of these types of funds that we just don’t have room for in a letter. Keep in mind, too, that there are many ways to invest. Each comes with its own advantages and disadvantages. Different professionals may say that one is better than the other, but what’s important is choosing what’s right for you. That’s why it pays to take a little time to educate yourself on how they work and what they’re for.
That’s why we’re going Back to Basics.
In our next article, we’ll pivot away from investing to something a little more personal.
1 “What are Mutual Funds?” Securities and Exchange Commission, https://www.investor.gov/investing-basics/investment-products/mutual-funds
2 “Index Funds,” Securities and Exchange Commission, https://www.sec.gov/fast-answers/answersindexfhtm.html