When you start investing, there are several options as to where to invest. You can buy stocks or bonds of a specific company or you can buy a fund that holds several different types of stocks or bonds. There are three types of funds: ETFs, Mutual Funds, and Index Funds.
What are they?
An ETF is an Exchange Traded Fund. It usually isn’t actively managed, and its goal is to track a certain index or sector. A mutual fund is actively managed by a portfolio manager and its goal is to beat a benchmark. An index fund is a combination of the two.
What are the characteristics?
An ETF is a passive investment, which means the stocks or bonds that make up the fund are not bought and sold often. The fees or expenses associated with and ETF are low, and can reach .03% of Assets Under Management (AUM). They also trade like a stock. You can buy and sell ETFs throughout the day, and also put limit orders, stop orders, or even sell them short. Taxes associated with ETFs are often low because the investments that make up the fund are not bought or sold frequently. However, you will have to pay capital gains taxes if you had the fortune of buying low and selling high.
Most mutual funds are actively managed, which means the portfolio manager buys and sells as much as needed in order to beat a certain benchmark. That benchmark could be any index, like the S&P 500. There is more time and effort required to manage a mutual fund, so the fees or expenses associated with it are usually higher. The industry average is .78% of AUM, according to Morningstar. A mutual fund does not trade throughout the day, so if you enter an order to buy a fund at 11 am, it will be processed at the end of trading when all funds are calculated. Taxes for mutual funds can be higher because the manager is selling more investments.
An index fund is essentially a combination of the two. It is designed to track a certain index, like the Nasdaq. Similar to an ETF, it is passively managed so the expenses are usually less; some can be below .10% of AUM. Also like the ETF, taxes are normally less because there is fewer selling of assets.
Which one is best for me?
The type of fund that is best ultimately depends on your risk tolerance, time horizon, and your style of trading. If you want to reduce risk by dollar cost averaging, an index fund would be best. If you would like to place various types of orders, like limit or stop orders, an ETF would work better. Or if you want to try and beat an index, you could choose a mutual fund.
The fact of the matter is, is there are many different types of funds you can choose from. You should first take into account what your risk tolerance is, what your time horizon is like, and what your ultimate objective is. Mutual Funds and ETF's are sold by prospectus only. Investors should consider the objectives, risks, charges and expenses of the fund carefully before investing. The fund prospectus contains this and other important information. Dollar Cost Averaging is the strategy of buying a fixed dollar amount of a particular investment on a regular basis. Past performance does not guarantee future results. Please consult a tax advisor or financial adviser before investing in any security.