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Whether or not you know what a fund is, the chances are that you already own one in your 401(k) plan. Join me on today’s hike as we learn about two types of funds: Mutual Funds & Electronically Traded Funds (ETFs)
In their simplest form, mutual funds and ETFs are companies that buy and sell investments. They do this to make money for their owners, who consist of: You, Me, and their fund manager! Now the difference between funds and a regular retailer is how they make their money. Standard companies sell either a product or a service. In contrast, funds sell ownership of the investments they hold and manage.
How funds manage the investments they own varies from fund to fund. Still, the easiest way to understand funds is to think of them like backpacks: Funds transport your money to an end destination (i.e., retirement, university, or other financially backed goals). Hence different funds are like different backpacks. Some funds are day packs meant for shorter time periods; others are expedition packs intended for longer durations (i.e., you do not need the money for decades).
Further building on this analogy, some funds can be tailored to a specific need. In contrast, others funds are intended to fit various purposes (think of all-purpose packs versus hiking or computer ones). In the world of funds, this example is illustrated by a variety of funds that can be broad-based and invest in the entire stock market, compared to specialized ones that invest solely in electric vehicle manufacturers.
Now how do funds operate? They go out and buy securities, i.e., the actual investments, to accomplish whatever they decide is their strategy or specialization. Some funds buy stocks, others buy bonds, and some buy a mixture of both (or other things entirely)!
The beauty of funds is rather than going out and doing research and then buying the entire stock market or area of it yourself, a mutual fund or ETF can do it all for you. As a result, funds tend to be popular amongst investors. They also benefit from diversification since they lower investment risk by spreading it across multiple investments versus just one.
Ask any financial advisor or guru; they will tell you diversification is key to a well-constructed portfolio! Why is this, though? By spreading the risk of betting on one company by betting on multiple companies, you increase the chance that you will pick a winner rather than a loser. While one given stock may go down due to what the company executives do, the entire industry or the entire stock market likely will behave differently. Thus you are less likely to lose!
Diversification means less risk, and less risk means your hard-earned dollars are more likely to be there in the future when you need them!
But what about the costs?
Running a fund requires having an office, employees, and buying and selling stocks and/or bonds. Inevitably, someone has to pay for this. With funds, the costs are bundled together and referred to as the expense ratio. Who pays the expense ratio? The customer, who is the investor!
Expense ratio = (Total costs to run the mutual fund / all of the assets of the fund) * 100
We multiply by 100 to express the ratio as a percent
Fund ABC costs $100,000 a year to run and has $100,000,000 in investments that it owns.
$100,000 / $100,000,000 = 0.001 which is expressed as a percent so 0.001*100 = 0.1%
Just as with all companies, these costs happen regardless of whether or not the fund makes money; i.e., you pay it when the stocks owned go up, down, and side to side! [For an in-depth read on expense ratios, check out this article]
What about revenues, though?
Are funds like a regular business when it comes to revenues? No, they differ because the revenues a firm has can be realized or unrealized. Additionally, instead of being called revenues, they are referred to as gains.
Gains are the amount that an investment rises by, meaning that a loss is an amount that an investment decreases by. For a gain or a loss to be realized, you have to sell the investment; until then, it is unrealized and has not been locked in. Generally, the goal of a fund is to make money by investing in the market through either stocks or bonds. As a result, an unrealized or realized gain is good for you because it increases the price of the mutual fund since those original dollars are now worth more.
The price you paid for a mutual fund, sell it for, and that tracks its current value is referred to as the Net Asset Value or NAV for short.
NAV = (Value of all assets – costs or expenses)/total ownership shares in the mutual fund
So as the value of the money you put in goes up, the NAV will go up too. Thus when you decide to redeem your shares in the mutual fund after this occurs, you now have more money to withdraw. The flip side is that if the investments held go down, you lose money because you have less to withdraw!
But wait! Funds can have another type of revenue which comes from dividends and/or interest payments originating from the investments the fund holds. With stocks, companies issue dividends, which are payments of profit to all stock owners. With bonds, companies issue interest payments, which are a fee you collect for letting the company borrow your money.
Tying it Together
So if we tie this all together, we now understand how expenses and revenues work for funds, meaning we know our profits! We simply subtract costs from our gains (unrealized and realized plus our dividend/interest payments received). The resulting number equals the fund’s yield. Instead of using the word yield or profit, financiers use the word performance. Fancy, I know! Performance lets us standardize how much a fund goes up and down, and it is measured daily. Standardization allows investors to evaluate which funds to invest in since all funds are comparable (apples to apples).
Fund performance = Gains or Losses – Expenses
Thus, when you see the performance history for mutual funds, you now understand that it is always after expenses.
How to Buy & Sell Funds
Now we know how mutual funds and ETFs work. To recap: Funds buy/sell investments on your behalf to try and make you money, charging a fee known as an expense ratio to cover their costs in this endeavor.
The difference between mutual funds and ETFs is how you buy and sell them. With mutual funds, you do business directly with the fund, and with ETFs, they are exchangeable with anyone.
Think of mutual funds as a bank deposit: You go to your bank and deposit money. They pay you interest until you withdraw the money, and when you withdraw it, you do so directly from them. As a result, you can deposit or withdraw any amount (whether it be $1 or $1,000).
With mutual funds, since you are exchanging your holdings with one company, they decide when you can buy and sell your fund holdings. To make this easy, all mutual funds process exchanges once per day, at 4:00 PM EST.
Now, this doesn’t mean you cannot put an order in to buy or sell that fund before/after this time. It does mean that your exchange will occur until the next time that mutual fund processes exchanges, though.
ETFs are like collectible trading cards: You can buy them directly from the issuing company or in the market from other investors who now hold them.
Since ETFs are exchangeable between anyone rather than one company, their purchases and sales are standardized and sold in terms of shares. Now shares is a fancy way of saying the number of units you want to exchange at a given price for that ETF.
With ETFs, you can buy them from any investor or the company issuing them when the market is open. The market is generally open Monday through Friday between 8:30 AM-4:00 PM EST. As a result, and just like collectible trading cards, their price can change throughout the day.
Just like with mutual funds, ETF prices a determined by the NAV. Uniquely though, they have bidding and asking prices based on how many people are currently buying or selling them. The bid is what a buyer will pay, and the ask is what a seller wants to receive. The difference between these two amounts is known as the spread. Simply put, this means that supply and demand can move the actual price away from the NAV and usually, this is a trivial amount for larger and more frequently traded ETFs.
Whoa, we did it! You now know the differences between mutual funds and ETFs. When choosing a fund to buy, mutual funds and ETFs can both be great options, but there are standout reasons for owning either.
ETFs are often better suited for investors who want to trade in or out of the market during the day. Thus, ETFs can allow for just that for those who want to be more active with their portfolios. With mutual funds, they are better suited for automated investment strategies, and flexible withdraws. Because you can generally buy a mutual fund in any dollar amount, most firms will let you automate this process on a weekly, monthly, or yearly basis. Additionally, when you are ready to withdraw money, you only have to sell what you need with mutual funds; you have to deal in whole shares with ETFs.
This limitation of ETFs for whole share transactions does not apply to customers of firms that allow for fractional ETF trading. Relatively new and not available at every firm yet, fractional trading lets customers sell (and buy) partial quantities of shares to receive specific dollar amounts. Some notable examples of firms that allow this include Charles Schwab, Fidelity, and Robinhood.
So, which will you buy? Are you exclusively going to use mutual funds, or will you use a mixture of mutual funds and ETFs? Let me know in the comments below and why, but until next time thanks for joining me on today’s hike, and have a great day!
Mile High Finance Guy
finance demystified, one mountain at a time