Find out the similarities & differences between mutual funds and ETFs & which is right for you. Read this full breakdown of the pros & cons.
Getting started in investing — is not an easy thing.
It’s a complicated world full of terms like “dividends” and “compound interest,” “IRAs,” “yield curve” etc.
Among those terms, Mutual Funds and ETFs, in particular, — seem to be two of the most commonly misunderstood concepts in the investing world. Most people barely even know what a mutual fund or an ETF is — and even among those that do — when it comes to telling the difference between the two, there is often some degree of confusion.
So today, in this beginner’s guide to Mutual Funds and ETFs — I’m gonna break down the concepts behind the origin and purpose of both of these investment vehicles and talk a little bit about the main differences between the two.
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Some background on Mutual Funds & ETFs
So — to start with what mutual funds & ETFs are and what the basis was for the creation of these investment vehicles — I’ve got a little story for you guys.
This is Claude — he lives in a small port town in the US, back in the early 1800s.
Now Claude is a huge coffee fan and he really wanted to invest his money in where his passions lied. So he started to look at different ways he could get into the coffee market. There were a handful of coffee shops in his town that he could buy stock in or there were a couple of good coffee plantations that produced coffee beans near his area that he could invest in…. but he just wasn’t’ sure which one to pick.
Ultimately, after a few weeks of research and some careful pondering, Claude decides to invest in this one coffee plantation on the southern border of his town. So he purchases 500 shares of stock in this southern coffee plantation and he brags to all his friends about his new investment. His friends all agreed that the coffee market is a great place to put your money to work — but one of his friends, decides to invest in the northern coffee bean plantation and a few of his other friends decide to buy stock in some of the local coffee shops in the area.
Well, in the first year, both the northern and southern coffee plantations did great at producing enough coffee beans and in turn, the local coffee shops that procure these beans from the plantations also did very well — business was booming and everyone’s return on investment was High. Claude was especially proud of the fact that he was the one that turned everyone on to investing in the coffee market.
Now in year two, something unfortunate happened. The southern coffee plantation, in which Claude was heavily invested — experienced a brush fire and lost more than half of their crop. Seeing as how the southern plantation could no longer fill the purchase orders of the coffee beans needed by the local coffee shops, most of those shops switched to getting their supply of beans from the Northern coffee plantation instead.
At the end of the year, the value of the southern coffee plantation dropped by over 30% and Claude lost all of the gains he had made from his first year of investing in the coffee market. Meanwhile, his friend that bought shares in the northern coffee plantation and his buddies that were invested in the local coffee shops all made positive gains and were celebrating their good fortune!
Claude was devastated — he really just wanted to invest in the coffee market as a whole, not just in this one plantation, and if there was a way to do that back when he started investing — he may not have lost so much money, b/c clearly the rest of the coffee market did just fine.
That sparked a thought in Claude — what if there was an easy way to invest in the total coffee market as a whole? He thought about this question for a while and then came up with a brilliant idea — he would create an basket of investments that contained one share of stock of each of the top 10 coffee businesses in his town. This grouping of stocks would be a good representation of the entire coffee business in his town and it would mitigate the downside of any one of those businesses having a bad year by spreading the risk across all 10 stocks.
But to buy all 10 stocks, would cost Claude a lot of money… so he decided to convince his friends to join his cause and mutually contribute to his new basket of investments. They could all equally fund the basket together and mutually divide the ownership among themselves.
His friends all agreed that it would be much safer and more practical to own this basket of mutually funded assets together — and thus the Mutual Fund was born.
And through the course of the next few years, more and more people decided to join-in and fund Claude’s new mutual fund which definitely kept his hands full — in managing the performance of this fund.
You see — since Claude only had room for 10 different stocks in his fund — whenever he saw one of these stocks not performing well, he would sell them and buy a different coffee business stock to take its place — this way, his Coffee mutual fund would always consist of the BEST businesses in this industry, thereby aiming to actually outperform the performance of the total coffee market, as a whole — and in essence, providing a higher return on investment compared to the overall coffee industry.
And for all of his hard work in managing the portfolio of this fund — Claude took a percentage of the fund’s profits as an expense fee.
With Claude’ expert portfolio management skills, the individual performances of the 10 stocks in this fund, and with more and more new investors coming in to participate in the fund, the next couple of years have been great for Claude and the overall coffee industry.
Now seeing the success that Claude has had with this Coffee Business Mutual fund and all of the money that he’s been making by managing the portfolio — a lot of other people decided that they too wanted to develop their own mutual funds. Some created similar funds that tracked the coffee industry — so that they would directly compete with Claude’s fund — while others created entirely different funds that tracked different industries, like the fishing market or textiles market, or precious metals etc. Some even created mutual funds that focused on a particular strategy, rather than a specific commodity, like for example — making a fund comprised of only all large companies or ones that focused on the growth of a particular city or region holistically.
And then one day — this one guy named Thomas, came along.
He loved the idea of mutual funds but there were also a couple of things that he didn’t like about them.
First, he didn’t like the idea of paying all of the portfolio managers, like Claude, these expense fees to constantly rebalance and manage the mix of stocks in the fund. He wasn’t keen on the idea of the performance of the fund relying on the skills of this one person to accurately predict the direction of the market and he wasn’t really clear on how much of a performance difference this management work really made anyways.
Secondly, because these funds were all actively managed there is a lot of work involved with rebalancing of the assets in the portfolio which also leads to recalculations of the mutual fund prices and other management processes. As a result, mutual funds can only be purchased and sold once at the end of the day, after the stock market has closed. Thomas didn’t like that so much — he wanted to be able to freely trade his shares of mutual funds any time he wanted in the open exchange, just like normal stocks.
Thomas decided that he would create — just such a fund that would have these characteristics.
He gathered some participants, pooled all of their money and went out and bought up one share of EVERY coffee-related company in the entire town — and what he told his investors was that he was NOT going to actively manage this fund — but rather just passively monitor it to make sure the fund simply mirrors the performance of the entire coffee industry as a whole, as opposed to trying to outperform it.
This sounded a little underwhelming for his investors, so Thomas also added the fact that because he is not actively managing the fund — the expense fee that he would take out of the fund was next to nothing, meaning that the investors would keep more of their profits. And because there were fewer management processes, he would also be able to make the shares of this fund easily tradeable in the open market, during normal business hours, so if at any time, his investor wanted to buy more or exit their shares, they had the flexibility to do so.
This seemed to make sense to everyone — and thus the first ETF, or Exchange Traded Fund, was born!
And pretty soon, the idea of ETFs spread throughout the community- and just like mutual funds, there were numerous ETFs popping up left and right for just about every commodity, asset class and investment strategy that you can imagine.
Now, obviously, this is just an imaginary, story but it’s based on the same concept and theme behind why mutual funds & ETFs were created in the first place and what the purpose of these funds are.
So now that you know origin behind these investment vehicles, let’s bring it back to today and take a quick look at how Mutual funds and ETFs operate now.
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Mutual Funds and ETFs Similarities
In modern-day investing, there are a couple of important pieces of information you need to know about both Mutual funds and ETFs.
1) First, only licensed and registered financial service advisors or businesses can create and offer Mutual funds and ETFs to the trading public — there are obviously SEC regulatory requirements that need to be met for any investment vehicle in the stock market — so not just any person (like Claude or Thomas) can create these funds.
2) Secondly, both mutual funds and ETFs are required to have something called a prospectus — which is a type of summary fact sheet on the fund, which explains exactly what the fund’s strategy is, what the cost of the fund is, what the top equity holdings in the fund are (meaning what are the top stocks or other securities that are included in this basket of investments), who the fund manager is if it is an actively managed fund, what the expense ratio is — which is the management fee that goes to actively managing the fund — and other details on past, historical performance of this fund. This is an incredibly valuable tool to use when you are considering which mutual fund or ETF to include in your investment strategy.
Now, let’s take a quick look at the differences between the two investment vehicles.
Mutual Funds vs ETFs – The Differences
Nowadays the difference between mutual funds and ETFs are starting to blur, but in general, here are the two major differences.
1) As we discussed, ETFs are traded on the exchange, during normal business hours like a stock, while mutual funds can only be bought or sold once each day — after the market is closed. This gives you a lot of flexibility in purchasing ETFs because you can buy and sell them based on your stock strategy, employing all of the same order types you would normally use. On the other hand, Mutual funds give you a unique opportunity to see one day into the future to determine whether or not the price of the fund would go up or down at the time of your purchase. Let me explain what I mean here in a little more detail.
You see, when you place an order to buy or sell a mutual fund during the day — those order are collected and held until the market closes. Once the market closes and the rebalancing of the stocks within the mutual fund has settled, the fund then recalculates the fund’s price (which by the way, is called the NAV or the net asset value) before it processes all of these buy and sell orders. What this means is that the price that you buy in or sell of the fund is directly affected by the performance of the underlying stocks during that day’s trading hours. So if the overall market had a down day, that day — you can expect your purchase or sell of the funds’ shares to be at a lower price than what is currently showing. This gives you the ability to decide if you want to buy or sell on that day or wait until you see some different behavior in the market. (If you’d like to follow along in video, click here.)
2) The second difference to note is that Mutual funds are generally actively managed, ETFs generally passively managed. Again — we’ve also talked about this in the story I told you guys earlier, but just to refresh your memories:
Actively managed funds, like most mutual funds, have a portfolio manager that works to optimize the composition of the fund to beat the index or market that they are tracking towards. Whereas most passively managed funds, like most ETFs, aim to simply mirror the performance of their indexes. As a result, mutual funds generally charge a higher expense ratio compared to ETFs. It’s something to keep in mind and you do your research into these funds.
So that sums up the concepts behind the origin and purpose of mutual funds and ETFs — I hope you found this both educational and entertaining.
When you’ve found the right mutual fund or ETF that fits your long term growth strategy, it can be one of the best and most optimal investment choices you can make.
Related articles:
- How to Triple Your Return With Advanced ETF Strategies
- ROTH IRAs – Why Now Is The Best Time To Start One
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The content here is strictly the opinion of Daniel’s Brew and is for entertainment purposes only. It should not be considered professional financial investment or career advice. Investing and career decisions are personal choices that each individual must make for themselves in accordance with their situation and long term plans. Daniel’s Brew will not be held liable for any outcome as a result of anyone following the opinions provided in this content.
