Mutual & Exchange Traded Funds

Mutual Funds are one of the most popular and widely used investment products (vehicles) within the United States (U.S.). There are over seven thousand mutual funds circulating worldwide and over six thousand Exchange Traded Funds (ETFs) since their inception in the early 1990’s. In this section, we will learn more about what Mutual Funds and ETFs are and why individuals invest in them.

Mutual Funds

A mutual fund is an investment product that pools money together from many different investors in order to create a portfolio based on one stated objective of the fund. Money invested into a mutual fund may be allocated into stocks, bonds, cash, or commodities. Some mutual funds only invest in one or two of these investment categories, also known as asset classes; these funds are known as specialty funds.

A mutual fund is much like a shopping mall. A shopping mall is a collection of individual businesses that form a complex, or shopping center. Each business is generally independent from one another, however; they all operate under one building. In this example the building is the mutual fund and the stores within the mall are the investments that make up the portfolio, or shopping center complex.

Mutual funds are created and managed by investment companies, such as:

  • Charles Schwab
  • Fidelity Investments
  • American Funds
  • Vanguard

Investors purchase shares in a mutual fund which represent their ownership of that specific fund. The owner of a mutual fund will never own the investments that make up the asset allocation of the fund. The investment company creates the fund and a prospectus for each fund.

The prospectus is a legal document that provides investors with information such as the stated investment objective, fees charged, and the personalized ticker symbol that identifies the mutual fund among other funds. Once a mutual fund is created, investment companies will work with other financial institutions, governments, and companies to sell their funds as investment options to customers, employees, and clients.

 

Mutual Fund Characteristics

Mutual funds have certain characteristics such as:

  • Investment Objectives which provide investors with intended goals and risks associated with how money invested into the fund will be allocated. For instance, a mutual fund with an investment objective of growth, will invest in stocks with a high expected future value and higher level of risk.
  • Net Asset Value (NAV) – Investment companies calculate the market price for their mutual funds at four o’clock New York eastern time, each business day. The market price for a mutual fund is the Net Asset Value (NAV). The value of all the securities within the fund are added together, expenses are then subtracted, and lastly divided by the number of shares outstanding. The NAV is the trade price.
  • Ticker Symbol – Like stocks, each mutual fund has a ticker symbol, which abbreviates the funds name and represents the investment company that created the fund. This symbol is printed and circulated to provide fund information such as the NAV.
  • Domestic Funds are mutual funds that invest in stocks and bonds issued by U.S. companies are known as domestic funds.
  • International Funds are mutual funds that invest in stocks and bonds issued by companies outside of the U.S. are known as international funds.

 

Exchange Traded Funds

Exchange Traded Funds (ETFs) are very similar to mutual funds, as both are created by pooling investor funds together, in order to invest in a fund with a common stated objective. In fact, ETFs have many of the same characteristics as mutual funds, with one major difference between them – the way they are traded.

ETFs are bought and sold just like stocks, and their market values change throughout the day. Unlike mutual funds, an investor in ETFs knows exactly how much they paid for the fund without having to wait until market close at 4PM/Eastern Time in the U.S. ETFs also trade on stock exchanges, which has made them very popular, given similarities between them.

ETFs and mutual funds are known as either open-ended or closed-ended:

  • Open-ended refers to the investment company’s ability to create as many shares as it desires, so long as there are investors who want to purchase the fund.
  • Closed-ended refers to a specific number of shares that are issued by the investment company creating the fund. Shares are issued once based on an initial public offering (IPO). Once all the shares have been purchased, no new shares are issued.

It’s important to remember that although ETFs trade like a stock, they will always be managed and maintained by an investment company, similar to a mutual fund. The price of an ETF is reported as the Net Asset Value (NAV), just like mutual funds.

The NAV (Net Asset Value) of an ETF reflects additional details around the price, known as the premium and discount:

  • Premium price would indicate a difference in price above the NAV (Net Asset Value).
  • Discount price would indicate a difference in price below the Net Asset Value (NAV).

 

Passively Managed Funds

As we have learned, mutual funds and ETFs are products that are created by investment companies. These companies are responsible for choosing the investments such as stocks, bonds, cash, commodities within the portfolio to match the investment objective of each fund. Investment companies will assign portfolio managers to each fund.

Portfolio managers are generally employees of the investment company who are responsible for the management of the fund. The portfolio manager is responsible for buying investments that align with the investment objective marketed by the company.

Mutual funds and ETFs are categorized as either passively managed or actively managed. Let’s look at the passive approach to the investment selection process.

Passively managed funds are designed to replicate an index or fund. The index used will create what is known as the benchmark.

  • A benchmark represents a particular fund or index that is similar in risk and objective, which serves as a baseline for measuring a fund’s performance or rate of return. For example, if a fund’s investment objective is to invest in small companies, the fund’s benchmark may be the Russell 2000 Index, which is an index made up of 2,000 small publicly traded companies.

Portfolio managers who are responsible for passively managed funds do not attempt to increase the rate of return for the fund above their benchmark. Their job is to match the investments within the fund as closely as possible to the benchmark, preferably identical in nature to mimic the exact composition of the index being used. 

Actively Managed Funds

Actively managed funds are investment products created by investment firms to provide individual investors with additional options to invest their money, for both the short-term and long-term timeframe. Professional portfolio managers of actively managed funds are required to conduct a thorough analysis in order to determine which securities such as stocks, bonds, cash, or commodities meet the likelihood of outperforming their industry peers.

A company’s industry peers are other companies that create a similar product and/or service. In order to compare one portfolio manager to another, financial services looks at the performance of each actively managed fund and further compares it to a benchmark.

Performance focuses on the rate of return for a fund. This also includes:

  • index (indices)
  • company/organization
  • industry
  • mutual funds and exchange traded funds (ETFs)

Portfolio managers of actively managed funds make investment selections, in order to achieve future above average rates of return or performance when compared to other funds. Given the fact that no one can predict the future, portfolio managers rely on financial investment reports and other analyses in order to make informed decisions.

For instance, perhaps you are thinking about upgrading your phone. Your reason for getting a new phone will determine who you choose for a cell phone service provider, the amount of money you spend on a phone, and accessories. Professional portfolio managers go through the same process in determining the best way to grow a portfolio through performance.

A company’s financial reports provide information on:

  • Historical financial reports of a company. This includes annual filings, any stock filings, mergers and acquisitions.
  • Current financial reports based on a securities market value, and pending corporate filings.
  • Forecast outlook on the ability to grow and make money during current and future economic conditions.

 

Fund Fees

Mutual funds and ETFs (Exchange Traded Funds) both have fees. Fees of a fund are used in order to pay salaries to the portfolio manager and cover other operational expenses that essentially keep the lights on for the fund. Fees are also evaluated by investors to determine if a 

fund is too expensive when compared to similar funds. Fund fees are broken down into two categories: shareholder fees and annual operating fees.

  • Shareholder Fee refers to transaction fees charged to the investor when shares of a particular mutual fund or ETF are bought or sold. These are usually a one-time cost and include:
    • Sales Charges and Loads – these fees are charged to investors at the time of purchase. This is the “cost of doing business,” regarding the process of buying and selling mutual funds and ETFs. Some funds have what is known as a deferred sales charge, which means an investor will not be charged a fee upfront when buying the fund, but will have a fee sometime in the future based on details stated within the prospectus.
    • Redemption fee – is charged when an investor wants to sell shares of a mutual fund in exchange for their money, this process is known as redeeming. Redemption fees are charged by investment companies in order to cover the overhead expense of processing redemptions from funds.
    • Exchange Fee – investment companies will charge an exchange fee when investors want to change the fund they are invested in. Exchange fees are imposed when changing from one fund to another, whether it be between the same type of funds (fund family) or otherwise.
    • Account Fee – is charged to individual investors of funds where their investment falls below a specific value.
    • Purchase Fee – is charged when an investor buys a fund. This fee helps to reduce the expenses incurred (sustained) to the investment company in integrating your investment into the overall portfolio of the fund.
  • Annual Operating Fee refers to continuous expenses that will always be applicable in maintaining and operating the mutual fund or ETF, including advisory fees, marketing and distribution expenses, legal and accounting expenses. Annual operating fees include:
    • Management Fee – this fee covers expenses regarding investment selection and management within the fund. This fee is paid out of the fund’s overall assets to investment advisors that work with portfolio managers to meet the performance benchmarks.
    • Distribution and/or Service fee – this fee is most known as the “12b-1 fees,” which was created in order to cover expenses regarding marketing, selling, and maintaining the funds compliance with regulators. These fees are paid directly out of assets within the fund and include commissions to brokers, cost of printing and mailing prospectuses and sales material.
    • Other expenses – this category includes fees that do not fit under other categories. This may include accounting expenses, fees to custodians, legal expenses, and other administrative costs.
    • Total annual fund operating expense is the total amount of all fees charged by the fund and investment company. Generally, this fee is shown as a percentage of overall assets within the fund.

Most fees and expenses are paid by the investor; however, at times, investment companies may offer waivers to reduce fees or eliminate specific expenses. All details regarding fund fees and expenses can be found in the prospectus, in a section closely titled to shareholder fees and expenses.

 

Investing in Mutual Funds & EFTs

Now that we have learned about what mutual funds and Exchange Traded Funds (ETFs) are, how they are managed, and the fees involved with investing in them,  we will now look at how to invest in them.

Mutual funds and ETFs are the most widely used investment product. At work, you can add to a retirement account that invests your money in mutual funds or ETFs. If you are saving for college, most of the college savings accounts also invest in mutual funds or ETFs. And, you can use a brokerage firm, or directly invest yourself, to purchase shares in mutual funds or EFTs.

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