Explaining Mutual Funds & ETFs’

Technology over the past 20 years has completely revamped almost every industry. It has created millions of jobs and at the same time eliminated millions of remedial tasks society was accustomed to. In finance, this same story holds true with how we monitor, maintain and implement investment decisions. I would say technology has dramatically improved our day to day lives but to quote Louis C.K…

Everything is awesome, and nobody is happy.

Today, it has never been easier to invest. In less than 5 minutes, you can open an investment account, fund it, and buy hundreds of stocks. In years past, it took weeks or maybe months. So before we go into these fund structures, let’s take it back a few years.

Let’s say its 1901 and you want to start investing. How would you get started?

You would have probably had to find some stockbroker and then buy some individual stock. No diversification, no online account access, and no way to verify your broker wasn’t a crook.

It wasn’t until 1924 when the first mutual fund would provide investors with an option to diversify their investments. No longer buying ownership of an individual company but now the ability to buy a basket of companies with someone to manage and monitor the underlying businesses.

To try to keep this example as easy as possible, the best way to understand these various investment “vehicles” is by thinking about them like cars (pun intended). Whether it’s a mutual fund, ETF, or any other pooled investment, most are simply the different packaging of the same underlying components.

It doesn’t matter what car you pick off the lot at Enterprise Rent-A-Car, they all come standard with tires, breaks, airbags, seats, and an engine.

The same is true with investment vehicles but now the components change. All mutual funds and ETF’s come standard with individual stocks, individual bonds, currencies, commodities, or some other investment packed inside. The word mutual fund or ETF is synonymous with Sedan or SUV in this example.

Saying “I want to buy a mutual fund” and “I want to buy a sedan” are both identical statements. You need to then figure out whether you want to buy a Ford or Chevy just as you need to decide between Vanguard or BlackRock.

So let’s start with a quick overview of what a mutual fund actually is.

As mentioned above, a mutual fund is simply a basket of some underlying stocks, bonds, or other investments. If we think about the common S&P 500 Index, which represents 500 individual publicly traded companies in the United States, a mutual fund allows you to make one purchase and get a small exposure to all 500 companies.

Source: FI By Design

The logistics of how mutual funds work are pretty easy:

  • First, Investors pool their money together with a fund manager
  • Next, The fund manager buys a bunch of securities
  • Then, The securities generate returns (losses)
  • And Finally, the returns (losses) are passed back to the investors

Mutual funds simply allow investors to invest collectively into some asset class with the hopes of generating positive returns. This disruption in 1924 allowed investors the opportunity to have investment oversight, diversification, and a simplified solution to begin their investing career.

Now, just as mutual funds disrupted the individual stock marketplace, ETF’s have begun to disrupt the mutual fund market. With a focus of passive investing along with tax and capital gain concerns, the first ETF began traded in 1993.

So what exactly is an ETF? Let’s ask Vanguard:

Source: Vanguard

To summarize, an ETF is simply a fund made up of individual securities that trade on a stock exchange.

ETF’s do the exact same thing as a mutual fund when it comes to diversifying your holdings, however, the method of buying and selling differs to a degree. Mutual funds are redeemed directly from the fund company, where the stock market bids the price of ETF’s up and down based on investor sentiment.

There are some structural differences to the ETF’s that improve the tax efficiency but simply understanding they are funds at the end of the day is sufficient for the average investor.

BlackRock, one of the largest ETF providers, put a solid overview of mutual funds, ETF’s and stocks in the table below:

Source: BlackRock

So as investors, what are we to take away from all of this?

The quick answer is that as technology keeps advancing, we have to expect the way we invest to change. As new, easier, and more cost-effective ways to invest come about, new products will emerge shortly after.

I think looking at this entire marketplace like a car dealership will really help clarify a few things and help create a visual for newer investors.

Think of any investment company like a car manufacturer. Vanguard being Ford in this example. 

Vanguard offers a ton of investment vehicles on their lot that you can review, analyze and eventually drive. Not every car is right for every driver, just as not every ETF or mutual fund is right for every investor portfolio. Know what you’re in the market for before aimlessly wandering down the lot.

Also, just as your local family can open a self-named Ford dealership, individual advisors can self-name their own practice and sell Vanguard funds to their clients.

Steer clear of the used car salesman!

If you simply google car salesman, the photos that pop up are hilarious. The scary thing is that the financial industry is riddled with these salesman trying to pitch whatever mutual fund or other investment product they can make a quick buck on. As product costs have dropped so dramatically over the past decades, so has the need to pay someone a fat commission to buy a mutual fund.

If your working with an investment company, stop to evaluate how you are invested. Are you in mutual funds or ETF’s? Are there any commissions? Do you pay a management fee? All easy questions that need to get answered.

Don’t get too hung up on one manufacturer

Our goal is not to get stuck too much in the Ford vs Chevy conversation but instead on the concept of transportation altogether. We drive a vehicle to get us from point A to point B, just as we buy a mutual fund to grow our wealth from A to B. Ford is not driving your car but instead picking and organizing the components. The same is true with Vanguard and BlackRock. They are packaging you a “vehicle” of investments to hopefully drive you to retirement.

If we purchase the wrong car and have issues with the performance, the issue is on us for making the poor decision. Brand loyalty only means so much at the end of the day and as investors, we should be focusing on the best investment opportunity for our money at all times. Not the shiniest vehicle on the lot.

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