When you think of someone making an investment in the stock market, what do you envision? Perhaps you picture a coworker standing at the water-cooler, mentioning his or her recent stock pick that they're confident will prove to be a winner, or a stockbroker in a suit, waiving and yelling on the crowded and boisterous floor of a stock exchange, trying to lock in a purchase of shares in a specific company the investor thinks is poised for growth. In the modern era of investing however, there are many options for Americans looking to invest in the stock market that take on a much different form than buying individual company stock, such as investments into a fund that contains a basket of underlying stocks or bonds. Employer-sponsored retirement accounts often limit investment options exclusively to these kind of funds. The two most common kinds of funds that investors have access to and can utilize are Exchange-Traded Funds (ETFs) and Mutual Funds.
The primary difference between investing in individual company stocks versus ETFs or Mutual Funds, is that ETFs and Mutual Funds contain multiple underlying assets that you are investing in, rather than one asset like a company stock. Investing in a fund containing a variety of companies (even if strongly correlated, such as a tech fund, or a large-cap growth fund,) allows you to obtain exposure to the same types of companies you would like to invest in while diversifying to mitigate some of the risk. For example, consider that an investor is choosing between a fund that tracks the S&P 500 index which contains the 500 largest companies in the US, or investing directly in stock of a one of the well-established and respected companies contained in the index (sometimes referred to as a blue-chip stock). If you are invested solely in the company stock and the stock price drops by 20% due to issues with their product or service, a change in company leadership, etc., your investment return would effectively match the performance of the company, in this case losing 20%. However, if you invest in the index fund that holds that company and hundreds of others, a 20% drop in price for a single stock in the index would likely have a negligible effect on the fund as a whole as the successful companies in the fund can help mitigate the losses of the losers within the fund. This is one method of reducing your diversifiable risk by utilizing index-based ETFs and Mutual Funds as opposed to having your portfolio concentrated in individual stocks. It is still possible to have insufficient diversification when utilizing ETFs and Mutual Funds if you are investing in funds that are highly correlated to each other, but in general ETFs and Mutual Funds are useful tools to avoid being tied to the performance of just a handful of companies.
While oftentimes very similar, there are some differences between ETFs and Mutual Funds to be aware of. Below are a few examples:
- Typically track an index or other benchmark and attempt to replicate. Most ETFs do not typically attempt to earn returns beyond what the market returns.
- Often have lower fund-level expenses than mutual funds. Most ETFs track a specific benchmark and do not have a fund manager making investment or allocation decisions which can drive up costs.
- ETFs also do not charge sales loads, which, if a fund has sizable fees and commissions, can eat into the returns of an investment .
- May be more tax-efficient for the investor, as capital gains are often created by fund managers turning over the holdings of an actively-managed mutual fund.
- Oftentimes intend to beat the market or achieve a specific return by utilizing certain investment strategies or tactics, although their success at achieving this goal is doubtful.
- Typically have higher fund-level expenses than ETFs which reduces returns. Actively-managed mutual funds have highly compensated fund managers actively monitoring the investments and potentially making strategic decisions around how the fund is allocated.
- .Mutual Funds oftentimes carry "loads", a sales charge or commission paid by the investor to invest in the fund. There are various classes of loads associated with different class shares of a particular fund or stock:
- Class A shares of stock typically carry a front-end load, paid when the fund is purchased with your total initial investment reduced by the amount of the load.
- Class B shares, which typically carry a back-end load, paid when you sell your shares.
- Class C shares, which typically carry "level loads", or a fixed percentage charged on a reoccurring basis such as annually.
- There are also "no-load" mutual funds which do not contain a sales load. These mutual funds frequently still have higher expense ratios than similar index-based ETFs, even with no load.
While there are pros and cons to investing in individual company stock, ETFs, and Mutual Funds respectively, ETFs have proven to be a valuable tool to obtain low-cost exposure to the desired asset classes that make up a diversified portfolio of investments. There may be limitations to what you are able to invest in, especially if you are within an employer-sponsored plan like a 401(k) or 403(b).
It would be prudent to review your available investment line-up to see what options are available to you, and do due diligence on any investments you are considering putting your hard-earned money into. If you would like some assistance in reviewing what options are best for you, contact a fee-only fiduciary financial advisor like Fullen Financial Group.
About the Author:
Justin Seidenwand is an Associate Financial Advisor at Fullen Financial Group. He is a 2019 graduate of The Ohio State University, earning a Bachelor of Science in Consumer and Family Financial Services with a focus in Family Finance. Justin has years of experience in client-facing roles with an emphasis in relationship management, and he strives to help Fullen Financial Group build long-term relationships with clients and their families. While working to complete his education at The Ohio State University, Justin spent several years working in the telecommunications industry, and was also a formally-trained chef, attending vocational school for culinary arts while still in high school. In addition to his academic and professional achievements, Justin is also a six-year veteran of the Ohio Army National Guard, serving as a Military Police Sergeant in a team-leader capacity. Justin lives in Columbus, Ohio.
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