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Understanding Mutual Funds & ETF’s

Mutual Funds, ETF’s… What’s the difference?  Most investors invest their money through funds and for most, that means Mutual Funds.  However, Exchange Traded Funds (ETF’s) have been coming on strong in recent years.  What are funds?  What are the differences between the types of funds?  These are the questions we’ll be looking at in this new series of posts.

Diversification

A fund is a portfolio managed for the benefit of its investors with a particular style or sector typically established.  Because many assets are owned by the fund, it offers the investors the ability to diversify away specific security risk.  Think of it like this….Suppose you have an enormous window on the back of your house set up directly beside the 14th hole of your local golf course.  Now, let’s imagine that a golfer takes a bad whack and hits the ball through your window.

If you had one beautiful single pane of glass, you’ve probably enjoyed the spectacular view for many hours.  However, on this day, you’re going to have a very big problem when it breaks.  You’ll have to replace the entire window.

If instead, you had a multi-paned window, you might not have the same crystal clear view on a good day, but you will only be replacing one small pane on the day the golf ball bounces into your living room!

These different types of windows illustrate the advantage of funds and we’ve also tried to point out the disadvantage in our story.  A fund does not have security risk because it holds so many different securities.  If one security does extremely well, or extremely poorly, it does not make or break your overall performance.  The bad side to this is that if you bought an energy fund because you just knew that XYZ Energy Company was going to quadruple in size because of a huge new discovery and you also knew that this fund owned it, you would probably be disappointed if XYZ did actually quadruple in price because your fund would not see that big a jump.  XYZ would probably not represent more than 5-10% of the fund at the most (and often it would be less than 3%)

If on the other hand, you owned this fund and XYZ struck out on their drilling program and the stock went to Zero, your portfolio would not suffer nearly as badly because XYZ only represented a small part of your portfolio.

Remember that if you have a fund that focuses on energy companies, it will probably be pretty well diversified amongst the energy sector, but it will most certainly not be a diversified portfolio for you as an investor if it is your only holding.  If the entire energy sector falls much harder than the overall market, your portfolio will fall more than other investor’s do.

A fund (whether it be a Mutual Fund (Open or Closed End), ETF, ETN, Hedge Fund, or some other type we don’t name here) can invest any many different types of assets.  Of course the two most common are stocks and bonds.

Many people confuse the type of fund with an actual investment class.  The fund is the way in which you diversify your investment dollars across different assets irrespective of the asset class.  The fund might represent one type of asset (such as a sector) or it might diversify across many sectors.  The fund is the tool which holds the assets and thus diversifies your money (to the extent that the particular fund does diversify).

We’ve also recently started a series on asset allocation which in many ways relates to some of the purpose in funds, so you might want to check out those posts  Pt 1Pt 2, and Pt 3 can be found at these links.

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