And…we’re back! A few months ago, we started a series of letters called “Questions You Were Afraid to Ask.” Each month, we look at a common question that many investors have but feel uncomfortable asking. Because when it comes to investing, the only bad question is the one left unasked!
In our last post, we looked at two categories of investment funds – passively managed funds and actively managed. Both come with their own pros and cons. But regardless which categories you choose to invest in, there are many types of funds within those categories. This month let’s look at three of those types. This is important information to know, because many IRAs and 401(k)s will give you the option of choosing from at least two of them.
Questions You Were Afraid to Ask #5:
What Differentiates Mutual Funds, Exchange-Traded Funds, and Hedge Funds?
Let’s start with mutual funds, one of the oldest and most common ways that people invest. 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
As we’ve already covered, mutual funds can be either actively managed or passively managed. Regardless of which umbrella the fund falls under, though, many investors flock to mutual funds because they offer several potential benefits:
- Simplification. Mutual funds can simplify the process of investing because instead of devoting time to researching dozens – or even hundreds – of individual companies to invest in, the fund does it for you. (Note, of course, that you or your financial advisor should still research which fund is right for you.)
- Diversification. Mutual funds often invest in a wide range of companies and industries to meet the funds stated objective. This could lower your overall risk. This means that if one company/industry does poorly, you may not experience the same kind of loss you would if you invested all your money in that company or industry.
There are potential issues with mutual funds, though. For example, sometimes, it can be difficult to understand what or how the fund actually invests (Mutual funds can differ drastically depending on their objectives, investing style, time horizon, and other factors.) Mutual funds are required by law to provide a prospectus to investors that explains how the fund works, but if you don’t know what you’re looking at, this information may confuse more than enlighten. This is why it’s important to do your homework. (And by the way, everything in this paragraph is true for ETFs and hedge funds, too.)
Mutual funds can also sometimes come with more expenses than other funds, too. They might include management fees, purchase fees, redemption fees and tax costs. These expenses can eat into your returns, thereby lowering your overall profit.
Finally, mutual funds may not be a great choice if immediate liquidity is a high priority. All mutual fund trades run at the end of day. So, for example, if you wanted to sell a mutual fund at the beginning of the day, hoping to avoid what you think the market will do, you will still get the end of day price. For this reason, some investors turn instead to…
ETFs, as they are often called, can be actively managed. More often, however, they track the companies in a specific index, just like an index fund. (See our last post for more information on index funds.) Otherwise, ETFs differ from mutual funds in a few 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.2 ETFs fully disclose all holdings held. This makes it easier to see exactly what you are investing in. It also makes it easier to see where you have overlap.
But of course, nothing’s perfect. Since ETFs can be traded like common stock, that might lead to trading 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 could make it difficult to sell your shares.
Most people will never invest in a hedge fund. They’re generally not an option when investing through a 401(k) or IRA. But we include them here because we often get asked about them – and for good reason! You often hear about hedge funds in the media, and they’re the subject of multiple films. While mutual funds and ETFs can be either passive or actively managed, hedge funds are always active. The idea behind hedge funds is that the manager can use all sorts of strategies and tactics to help investors beat the market while “hedging” – hence the name – against risk. Hedge funds often invest in non-traditional assets beyond stocks and bonds, too.
The reason hedge funds are not an option for most investors is because of the huge cost associated with them. Legally, to invest directly in a hedge fund you must be an accredited investor. Meaning, you must have a net worth of at least $1 million or an annual income over $200,000 to invest in one. Plus, you must be willing to stomach paying all sorts of fees that are much higher than your average mutual fund. For these reasons, while hedge funds may be right for some people, they’re simply not necessary for the average investor to save for retirement or reach their financial goals.
Whew! We’ve thrown a lot of information your way over the past few months, haven’t we? That’s why, for our final post of the series next month, we’re going to look at the most important question of all: How to know which investment options are right for you. Have a great month!
1 “What are Mutual Funds?” Securities and Exchange Commission, https://www.investor.gov/investing-basics/investment-products/mutual-funds 2 “ETFs vs Mutual Funds,” Kiplinger, https://www.kiplinger.com/investing/etfs/602576/etfs-vs-mutual-funds-why-investors-who-hate-fees-should-love-etfs