Understanding Mutual Funds and ETFs

autumn river

While mutual funds (and ETFs) can be your sole investing method, I use mutual funds primarily for diversification in my investment portfolios (and in my 401k because I have no choice). Diversification is a way to increase the chances you’ll make close to market returns and eliminates the chance of a major loss due to an event at one company. It does not eliminate the risk of losses due to declines in the market in general due to public fear or a decline in the economy. It is like the difference between buying one home without insurance and having the risk that a fire or tornado will destroy it and buying a $1000 stake in 100 homes scattered across the nation. You’ll still lose money if housing prices decline nationally, but one sink hole won’t wipe you out.

The flip side to diversification is that at best you’ll get the returns of the market. Because I believe that you can outperform the markets by selecting the shares of companies that have the best prospects for long-term growth, I reserve a portion of my investing account for single stocks. The size of that portion is based on a balance between my desire to grow the portfolio against the amount of risk I can assume. As the value of the portfolio grows, I shift a greater percentage to mutual funds to hold onto what I’ve gained.

A mutual fund is a company in which people pool their money to invest in a group of stocks. There are managed mutual funds, in which a manager selects stocks to purchase, and then there are passive funds that follow a specified strategy and pick stocks automatically to match that strategy. For example, an S&P 500 fund is a type of passive fund that buys stocks to match the returns of the S&P 500 index, a specified group of stocks. The stocks they buy are entirely determined by the make-up of the S&P 500 index. When the people who determine the index change one of the stocks, the index funds sell shares of the stock that was removed and buy shares of the one that was added.

There is nothing wrong with owning mutual funds. In fact, if you’re busy and don’t think you want to get into individual stock investing, go invest in a set of index mutual funds and ETFs. You’ll be just fine and way better off than a lot of your peers who don’t invest at all. Individual stock investing is just for those who want to try to get better than market returns, which are nothing to scoff at by themselves.

If you are investing in mutual funds, your main concern should be to minimize fees. You see, because mutual funds have so much money to invest and therefore need to buy so many different stocks, even if you have a very good fund manager, he will end up effectively “buying the market” anyway. This means that a fund that charges 2% per year will make a return 1.5% less over long periods of time than a fund that only charges 0.5%. This may not seem like much of a difference, but it will add up to millions of dollars over your working lifetime.

Because managed funds need to hire a group of fund managers, plus researchers, secretaries, accountants, and a personal pastry chef, they tend to have higher fees than passive funds. In theory having that crack group of highly trained, highly paid managers will cause you to make more money so you can afford to pay the extra expenses, but in practice your returns are the same before fees for reasons previously stated. It therefore makes sense to place your money primarily in passive mutual funds, meaning index funds and ETFs, unless there is a sector of the market in which you wish to invest and there is no passive fund available. You might also only have the choice of managed funds in your 401k plan, so you just need to accept the higher fees and move the money into an IRA when you can because you change jobs.

While it is not always possible to hold unmanaged funds for the reasons stated above, in general index funds and ETFs would be recommended for those following the serious investing strategy championed in this blog. There is no reason to give up the additional gains that can be had by reducing fees. History and logic both shown that managed funds will not be able to provide a return sufficient to offset the higher fees over long periods of time.

 Your investing questions are wanted. Please leave in a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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