Part of a typical financial independence plan is your investment account. If you don’t have one, go and open one right now! But what happens after that? What do you buy? Do you buy index funds? Mutual Funds? ETFs? Stocks? Options? The list goes on.
Investment in stocks, bonds or commodities has always been considered a preserve of the financially literate. Perhaps you’ve had an interest in such investments but are scared by terms such us the share index, bull market and other intimidating investment lingo. So you’ve put off your investment dreams. You’ve thrown your hands up in despair, declaring how difficult it is to dip your finger in the stock market. If that’s your experience then take heart in knowing that numerous others have been through the same. Today I’ll discuss mutual funds and ETFs since they tend to be hotly debated.
What are they?
Well, mutual funds and ETFs are, from face value, similar in character. This is how they operate: A group of individuals want to invest. Rather than them investing their money individually, they pool their funds and invest it in a diverse portfolio. They then calculate the total value of their investment and divide it amongst themselves to determine the shares owned by each member. That’s about it! However, there are some fundamental differences between the two.
So yes, your funds together with the funds of other investors are pooled together. The mutual fund then employs a portfolio manager to make all those fundamental decisions like which stocks to buy, which bonds to invest in, in short any and every investment decision is made by the portfolio manager. At the end of every trading day, the fund tallies the value of the investments, divides it by the number of shares and determines whether your share value has risen or dropped. And all this is dependent on the decisions made by the portfolio manager. In mutual funds you can only buy or sell shares once per day, after the close of trading. Is this a good thing? I’ll get into that later.
This stands for exchange traded funds. They are different from mutual finds in that there isn’t a portfolio manager involved in the decision making. To buy or sell your shares you operate the way you would when buying or selling stocks on the stock market, through a brokerage account. And you can buy and sell as many times in a trading day. But just like a mutual fund, your risks are spread across a series of investments.
Pros and Cons
Just like every other investment vehicle, these two have their dark and bright sides. And your choice on which one is ideal for you rests on whether these cons are a deal breaker or not.
Mutual Fund Pros and Cons
Since the mutual funds are run by the fund company’s portfolio manager, you don’t have to fold your sleeves and get your hands dirty. For beginners, this is a huge plus. You get professional guidance all the way so chances of making uninformed decisions are minimized. But there’s a down side to this professional management: higher costs. Mutual funds charge higher fees to finance the efforts of the portfolio manager. Also, the process involved in buying and selling of stocks is long and arduous. It requires a lot of paperwork which also translates to higher fees. Again, all these transactions can only be done at the close of trading in any given day.
ETFs Pros and Cons
ETFs are desirable because of their lower fees. The buying and selling process simply involves buying the shares directly from the brokerage account. Whilst mutual funds are said to attract average annual expenses of 1.42% ETFs attract just an average of 0.53% annually. Then, you can buy it sell your shares at any time and as many times as you wish within a trading day, just like you would with stocks. This gives you the flexibility to make strategic decisions so as to get the most out of your investment. On the flip side, ETFs aren’t fit for the beginner investor. Trading decisions rest wholly on your expertise or lack of so with other professional assistance your chances of success are diminished. You have to do a lot of market research and that amounts to time consumption.
The main distinction lies in how shares are traded. In mutual funds, when you want to buy shares, first of all place a buy order to the mutual fund company. The company then internally processes the order by determining who made the order and how much they’re willing to spend. Then confirmation documents are sent back and forth before the company handles compliance issues. Finally, the portfolio manager goes to the market to perform the transactions involved. Clearly all this involves piles of paper work in effect pushing up the fees involved.
In ETFs, to buy shares you enter the order with the brokerage firm then sit back. It’s that simple. Because of this simplicity, fees associated with EFT investment are kept low.
Both investment options have their proponents but it all boils down to your preferences. Mutual funds are good if you don’t have the time to follow market trends while for a more hands on investment experience with low associated costs, EFTs are your best bet.
In the context of financial independence, fees compound over time and could cut into your nest egg. Avoid high fees at all costs!
As usual, if you have any questions, Ask the Fellow!