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When you're just getting started with investing in the stock market, typically the first investment vehicles you're going to look at are mutual funds and ETFs. You see them advertised all over brokerage sites and you have somewhat of a clue mutual funds contain more than just one stock of a company.
But really, you don't know what is the difference between a mutual fund and an ETF. Are mutual funds better than ETFs? Why are mutual funds more expensive than ETFs?
It's good to learn this stuff before you speak with your financial advisor because before you know it they could have you invested in a mutual fund with over 2% in fees.
Two classifications for Mutual Funds:
These are the mutual funds you'll almost certainly only come across as an average investor. In open-ended funds, the purchase and the sale of the mutual fund shares occur directly between an investor and the fund company.
When more investors buy into the fund, more shares are issued. Regulations make it so there is a daily valuation process which adjusts the fund's price-per-share to show the changes in the asset value.
Closed-ended funds only issue a specific number of shares throughout the entire fund. They do not issue more funds as more money is invested in the fund.
The prices of the fund aren't determined by the net asset value (NAV) of the fund, but of by investor demand. If an investor buys shares they are typically made at a premium, or discount to the NAV.
The only mutual funds to be concerned with as a beginner are open-ended funds. Those are the ones you'll come across through a brokerage firm.
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Exchange traded funds (ETFs)
Three classifications for exchange-traded funds:
Exchange-Traded Open-End Index Mutual Fund:
Dividends are reinvested on the same day they are received. They're paid to the shareholders every quarter. Derivatives can be used in the fund and securities lending is allowed. These are the most typical ETFs you'll find available to buy within a broker firm.
Exchange-Traded Unit Investment Trust (UIT):
UITs do not automatically reinvest dividends. Instead, they pay cash dividends quarterly.
Exchange-Traded Grantor Trust:
This is similar to a closed-ended fund, but the difference is the investor owns the shares in the company in which the ETF is invested in. You'll also be able to acquire voting rights as a shareholder. Dividends aren't reinvested in the fund, they're paid out to the investors.
As stated above, the only one to be concerned with as a beginner is the exchange-traded open-end index mutual fund.
Differences between mutual funds and ETFs:
Mutual funds are usually run by a professional. Typically they try to beat the market, which as I mentioned previously, hardly ever works out for them. Unless of course, you've invested in an index fund, which is a specific type of mutual fund that's not actively managed.
ETFs, on the other hand, are passively managed. They track a specific index, for example, the S&P 500 index or the Russell 2000.
One of the biggest mistakes investors make is neglecting fees. Expense ratios can range from a measly .05% to a whopping 3% or more. In the short-term, it doesn't seem like much, but over a 40 year period, depending on how successful your investments have been, it could cost you millions.
ETF fees are typically lower than mutual fund fees. This is because of a few reasons:
No load fees: Load fees in mutual funds typically range from 3%-8%. Mutual funds try to claim they don't charge commission fees for trades, but this is basically the same thing. Load fees charge a shareholder a percentage of their investment to compensate the broker who sold their investment.
ETFs on the other hand, don't have load fees. ETFs pay brokers when an investor buys a share and they're compensated a percentage for it.
If you hold on to the investment for a long time, the ETF is much cheaper than a mutual fund. However, if you buy and sell them frequently, they're going to end up becoming much more expensive than a mutual fund.
No 12b-1 fees:
Mutual funds include these fees while ETFs don't. These are essentially advertising, marketing and distribution fees that a mutual fund passes over to shareholders. Fees include marketing the fund to brokers and investors.
Basically, every shareholder that currently is within the fund pays for that fund to acquire new shareholders by helping pay for the advertising of the fund each year.
Although most people don't adhere to this, ETFs were meant to be passively managed. Instead what usually goes on is people trade ETFs like they're baseball cards. Sometimes there are even commission charges when you buy them which can range from $4-$20. On top of that, there are the expense ratios which I mentioned above that can hurt you.
It defeats the whole purpose, but most people don't seem to understand the whole idea that the creation of ETFs was to provide a cheaper way for investors to buy and hold stocks for the long-term. ETFs are even cheaper than index funds, but end up being more expensive for the average investor because they trade so often, defeating the purpose.
ETFs can be bought in real time like individual company stock. Mutual funds instead can only be bought and sold when the market closes at their closing prices. They're not available to be purchased through 9:30am-4:00pm ET. Only before and after can you buy them.
Mutual funds can sometimes have a very expensive cost of entering. There are even those target date mutual funds that are supposed to help you retire with enough money by your expected retirement date that still require a $1,000 minimum.
ETFs don't require investment minimums. All they require is the share price in order to invest in it. That's much cheaper and way better for your long-term investment scenario, since now you know, you only need to hold onto an ETF investment for the long-term instead of treating it like the new fad of the year.
Overall, it really comes down to your investment discipline. ETFs are ultimately cheaper in the long-run, but they tend to attract people who love to trade instead of invest. If you don't think you can handle the trigger happy crowd in ETFs, you're probably better off investing in mutual funds (preferably an S&P 500 index fund).
That way, you can only buy and sell when the market is closed. Maybe you'll change your mind about selling by the time the day is over, so you'll actually get those millions you're working so hard towards.
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