Understanding ETFs and Mutual Funds

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Investing encompasses the acclamation of assets with the hope of eventually achieving a positive return and increasing wealth. Buying shares in a company or renting out a property in a booming neighborhood can prove to be good investments in the long term; these types of investments are part of a broader range of assets including bonds, currency, and derivative exchanges. Individual stocks, of course, are the most popular investment with around half of all Americans investing in either the NASDAQ or the NYSE.

However, diversification of stocks within sectors and in the market as a whole can prove to be challenging, especially when considering that many investors may not have the funds or the time to dedicate to maintaining a large portfolio. ETFs and mutual funds offer a simple way to approach diverse stock investing that relies on the stability of various market sectors.

What are ETFs?

ETFs, or Exchange-Traded Funds, are exactly what they sound like: investment funds that are traded on a stock exchange. These funds typically are a collection of stocks, commodities, or indexes within a specific sector or subcategory of the market. In a sense, the fund acts as a mini-model of that specific sector because it represents the sector’s main companies. Assets that make up the fund generally also make up a large portion of the industry.

There are many variables to consider when analyzing whether an ETF is truly representative of an industry. The respective sizes, the amount, and the balance of various assets and stocks can lead to a circumstance where the ETF may present more risk than the sector as a whole. This is because fewer companies, imbalance in portfolio proportioning, and lower valuations of companies and commodities give the fund inherent risk and do not provide the market stability.

The most prominent ETF is the S&P 500 Trust (SPY), a trust consisting of the 500 largest US companies. As a representative of the medium and large companies of the US economy, SPY is extremely stable giving around 10% return year over year. One advantage to investing in SPY instead of a collection of large US stocks is its diversity amongst sectors, meaning the only way for the trust value to decrease is with a recession of the entire US economy. SPY also avoids smaller companies that may pose risk because of a lack of financial history, giving it an advantage over a fund that encompasses all parts of the market.

What are Mutual Funds?

There are some key similarities and differences to note with Mutual Funds compared to ETFs. The most prominent is the management of the holdings. Under an ETF like SPY, the subset of assets is left unchanging; in a mutual fund, a third party manages a collection of assets that can change depending on the party’s predictions for the future state of the market. The managers of these funds are almost always professionals, giving the investor more trust in the mutual fund to outperform the market.

The general idea of Mutual Funds and ETFs is the same: collect a variety of assets and group them together to sectorize and diversify a portfolio. Many mutual funds have ETF counterparts with only small differences; one example is the Vanguard 500 Index Fund (VFIAX), a fund that practically mirrors SPY but is managed professionally by the private company Vanguard. Because of this, it experiences small changes in its makeup depending on current events and market conditions.

Trading

A key difference for investors between these two funds is the availability and flexibility of their trading. Since ETFs are present as a fund traded on an exchange, they can be freely exchanged on markets, giving more flexibility and simplicity to the investor when they want to buy or sell. On the other hand, a mutual fund is traded after the market closes by the private corporation and does not offer the same flexibility. Because of these characteristics, ETFs often favor short-term investors who want to have complete control of the ownership of their asset while mutual funds favor long-term investors who prefer to let the corporations handle the fund’s composition.

Assessing Risk

As noted, ETFs and Mutual Funds are a more conservative approach to investing because they act as collections of assets where positives often balance out or exceed negatives in performance. Both funds carry intrinsic market risk because the assets they contain are not protected from a potential recession or market collapse.

ETFs carry risk associated with their underlying assets; if the sector the fund covers is substantial and secure, then it brings less risk. However, in niche markets where future performance is not predictable, there is higher concentration risk. It is as if you are putting all your eggs in one basket; if the basket breaks, your investment breaks as well.

Mutual Funds also carry risk, but since they are more distributed and are traded outside of market hours, the risk does not entirely lie with the individual assets. Instead, the large part of Mutual Fund risk is the entity that manages the fund. Since the entity makes decisions each day to change the composition of the fund, the risk involved with these funds comes with the individual decisions. Since the goal of the entity is to outperform the market, there will inherently be more risk involved in their decisions because there cannot be a bigger return without bigger risk.

Evaluating Funds

Considering the multitude of assets that make up these funds, there are various ways to evaluate the current value and performance of them including ratios, ratings, price, and performance. An expense ratio can show how the payoff of a mutual fund compares to any expenses to sustain the management of the fund; a lower expense ratio means operating costs are cheaper per investor for the management company.

Another ratio especially pertaining to mutual funds is the turnover ratio, which shows the frequency of the buying and selling of assets within a fund. This ratio can explain the intent of the management company; a shorter turnover ratio means a high volume of trades and more reliance on the traders while a longer turnover ratio means a lower volume of trades and more reliance on the market.

Of course, historical performance of a fund is also a good indicator of future performance and potential volatility; since many ratings are based on past performance as well as independent analysis of the assets, these trends can be relatively accurate as long as there is no significant market or sector change that may affect them.

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