ETFs & Mutual Funds

It is important to have a basic understanding of the term fund, as it generally applies to a certain type of investment. While there are many different types of funds, they all follow the same basic ideas.

In a fund, investor monies are pooled to provide strength in numbers. Where it would be difficult for an individual investor with only $500 to own a large variety of stocks or bonds, a fund can own many different securities and allow the individual investor to own a small portion of all of them. Further, an investor in a fund does not have to worry about researching, buying or selling securities. This is left to a professional, called a fund manager. In exchange for his or her services, the fund manager receivers a percentage of total assets under management.

Broadly speaking most types of funds offer two main advantages to investors:

  1. Funds provide a means for investors to diversify their investment holdings across different types of securities or within a particular sector, regardless of how much money they have to invest.
  2. Funds can give investors access to specific investment strategies, implemented by an experienced investment professional.

There are two kinds of funds that all investors should know about. These are: Mutual Funds and Exchange Traded Funds (or ETFs).


ETFs

What Are ETFs?

The initials ETF stand for Exchange Traded Fund. While an ETF is a type of fund, it is really a unique investment vehicle that actually behaves much more like a stock.

ETFs are funds designed to mimic the performance a specific index or a particular sector. The company responsible for creating the fund, called the issuer, collects securities in specific companies, from financial institutions that already own the securities and deposits them at a custodial bank. In return the issuer gives the contributing institutions shares in the ETF. These shares can then be traded with other investors in the market, much like a stock.

The movement of an ETF’s share price will generally follow the overall value of the underlying securities, held at the custodial bank. An ETF designed to follow the performance of the oil sector might contain a selection of stocks in oil companies. An ETF designed to follow the performance of a particular stock market index will contain stocks in the companies tracked by that index. There are also ETFs that follow bond indexes and others that follow specific commodities, such as gold. These all allow an investor to gain exposure to a specific sector, index or commodity without having to actually buy and hold each of the underlying securities.

Why ETFs?

If, for instance, an investor had reason to suspect that gold was going to rise in price, he or she could simply invest in a gold ETF, instead of having to buy and store physical gold. We do not recommend dabbling in the risky area of commodities trading. However, this simple example helps to illustrate the simplicity that an ETF can offer.

The holder of shares in an ETF actually owns a portion of the underlying assets and can technically redeem his or her shares for the actual securities or commodities held at the custodial bank. However, since ETF shares can be traded on the open market like a stock, one can simply sell their shares for cash. Taking the case of the gold speculator, providing he or she was correct about the price of gold rising, his shares in the gold ETF would have also risen in value. These could then be sold in the market for a profit.

If an investor wanted to bet on the performance of the overall market, he or she could invest in an ETF that follows the performance of a large market index, like the S&P 500 or the Dow Jones Industrial Average. One of the best-known ETFs is called the Spider, an ETF that tracks the S&P 500 index.

ETFs summarized

In many ways, investing in an ETF is like in investing in a stock. When you purchase shares in a company, you do so because you anticipate that the company will increase it’s earnings and overall asset value. Assuming you were correct, you could later take any gains by cashing your shares out in the stock, market. Similarly, you would invest in an ETF if you anticipated that the value of the securities or assets held by the ETF were going to rise in value. Just like stock, you could later sell your shares in the ETF to other investors on the open market.

Like other types of funds, ETFs do charge fees. However since most ETFs hold a preset group of securities, they require less active management. As a result fees are generally very low, usually on the order of a fraction of a percent.

ETFs were first introduced in the U.S. in 1993. At the outset of 2013 there were more than 1,400 different ETFs offered in the U.S., with a collective asset value of more than one trillion dollars.

Selecting an ETF

While ETFs do provide a convenient and low cost means of diversifying one’s assets, it is very important that one do their homework before diving in to the world of ETFs. With so many ETFs to choose from, a little guidance can go a long way.

Our top investment advisors can assist you in selecting high quality ETFs that are right for you and your needs.


Mutual Funds

A mutual fund is a type of investment vehicle, which is often considered a good entry point for newer, individual investors. Like other types of funds, mutual funds pool monies from a large group of investors and invest these funds across a diverse selection of stocks, bonds and other securities. Each investor in a mutual fund owns a portion of the fund and shares proportionally in the fund’s gains or losses.

Mutual funds are administered by professional money managers, who invest the pooled capital in an effort to grow the net asset value of the fund. Net asset value (or NAV) is defined as the total value of all securities in the fund’s portfolio, minus any liabilities. At the end of each trading day the fund’s NAV per share (or NAVPS) is calculated by dividing the total NAV by the number of shares the fund has outstanding. Shares in the fund can be purchased at the current NAVPS. Most mutual funds regularly pay out capital gains to shareholders. These payouts, just as with stocks, are called dividends. Investors can also sell their shares back to the fund at the current NAVPS.

Understanding different types of mutual funds

There are many different types mutual funds, each offering different diversification strategies or a focus on different economic sectors. A mutual fund that targets stocks in a particular sector, such as technology or energy is called a sector fund. A mutual fund that invests mostly in bonds is called an income fund. The purpose of such a fund is to provide steady income to investors through bond yields (click here to learn more about bonds). Then there are funds that offer a mixed investment in both stocks and bonds, called balanced funds. Such funds typically offer lower returns but a higher margin of security.

Potential pitfalls of mutual funds

While mutual funds can provide investors with a means of diversifying their assets in one single investment, it is important that one understand what they are getting involved with before they dive in.

Like other types of funds, mutual funds also charge fees. However, many of these fees get rolled into other figures and often go unnoticed. Investors are usually surprised to learn just how many hidden expenses their mutual fund investments are subject to. The potential charges and expenses of owning a mutual fund include:

  • Sales Commissions

Some mutual funds charge a sales commission to the investor on top of the share price. This commission may it be charged at the time of initial purchase or when selling shares back to the fund, and it is paid to the salesperson that got you into the fund. This commission, sometimes called a “sales load charge”, can range from 3% -6% of your investment in the fund.

  • Management Fees

Annual management fees, generally range from 0.75%-2%

  • Transaction Fees

Many mutual funds also pass on transaction costs to the fundholders to cover the cost of their frequent trading. These fees can range range anywhere from 0.7% to 3% per year!

  • 12b-1 Fees

Some mutual funds pay out an annual commission to the salesperson that got you to invest in the fund. This is called a 12b-1 fee and is usually around 0.25% per year.

  • High Taxes

The turnover rate of the average mutual fund (meaning how often the fund liquidates old investments and buys new ones) is often above 100%. Unless you are trading within a tax-deferred account such as an IRA, high turnover means you must pay short-term capital gains taxes on a majority of your returns. With this tax disadvantage, a mutual fund that appears to have impressive returns may not be benefitting you much at all.

Selecting a mutual fund

At Dash we focus on long-term holdings and work to keep our own turnover rate as low as possible. In addition, we assist our clients to get into excellent, low-cost mutual funds, and we never take a commission for doing so. We’re always working with your best interest in mind.

Do you have questions about which mutual funds may be right for you? With over 10,000 mutual funds to choose from it can be difficult to know where to start. Our top investment advisors can assist you in selecting high quality mutual funds that are right for you and your needs.