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Investing 101: What are ETFs and Mutual Funds?

Diversification is important when investing, but how can recent college graduates with loans build diverse stock portfolios? The answer is they can’t – at least not by buying individual company stocks. Saving for retirement is important, but big companies like Amazon and Google have four-digit price tags attached to their shares. Can you really afford a stock that’s $1800 a share on your own? Sure, maybe if you and a big group of friends pooled money together, you could get the necessary funding. But where can you find a group of people to pool money with on investments?

Long ago, investment companies realized that small-time investors couldn’t buy all the stocks they wanted. So they developed mutual funds – investment products that hold a bunch of stocks at once, but can be bought and sold as singular securities. The mutual fund companies sell these shares to customers, who act just like a group of friends pooling money together to buy multiple stocks.

Exchange-traded funds (ETFs) appeared on the scene in the 1990s, giving investors even more opportunities for broad market exposure. Mutual funds and ETFs make up a hefty portion of the holdings in American retirement accounts, but why the distinction?  How do these two types of funds differ?

Pooling Money For Diversification

Modern mutual funds go back nearly a century to the Massachusetts Investors Trust, which launched in 1924. You can actually trace investment pools even further back to 17th century Dutch merchants, but the Massachusetts Investors Trust devised the investment product we still use today. Pooling money into a professionally managed fund gave less sophisticated investors a chance to compete with institutional money. Mutual funds growth continued in the 1960s and 70s, but cash inflows really picked up in the 80s when Americans began using them to fund 401k and IRA retirement accounts.

All the early mutual funds had a manager who picked stocks and made decisions to buy and sell. Investors who wanted to buy into the fund paid a fee, purportedly for the manager’s expertise in picking winners. The Vanguard Group, led by legendary investment mind John Bogle, changed the mutual fund industry by introducing index funds. Instead of a professional manager picking stocks, index funds tracked measurements of certain stock sections, called indexes.

For example, the Vanguard 500 Index Fund (VFINX) tracks the S&P 500, a stock index of the 500 largest American companies. What’s the prime benefit of this? No manager to pay! The fund buys and sells securities automatically, drastically reducing expenses to investors. Index funds were a new type of mutual fund, but like their predecessors, didn’t trade on stock exchanges. Mutual funds are rebalanced at the end of each day, so orders to buy aren’t filled until the end of the trading session.

ETFs Enter The Picture

Mutual funds had one huge drawback – the inability to trade on an open exchange. You couldn’t buy or sell mutual fund shares on the New York Stock Exchange (NYSE), you were forced to wait until the trading day ended for the daily rebalancing.

In the 1980s, a man named Nathan Most approached Vanguard founder John Bogle about an idea. Most wanted to develop a mutual fund-style product that could be bought and sold on the NYSE. Bogle scoffed at first, claiming that investors buying and selling while the market was open would drive up transaction costs. Undeterred, Most went back to brainstorming and eventually solved the transaction problem with the first ever exchange-traded fund (ETF).

The Standard and Poor’s Depositary Receipts was introduced on January 29, 1993, trading until the stock ticker SPY. As the first ETF, the SPY tracked the S&P 500 index and sold shares on the open market. To solve the transaction cost problem, Nathan Most developed “creation blocks”. Large blocks of 50,000 (or more) ETF shares were sold to institutions, who in turn sold individual shares to investors. Creation blocks made ETFs cheap to trade and money began pouring into the SPY. Like mutual funds, ETFs hold a basket of stocks based on certain characteristics such as growth stocks, large cap stocks, or other instruments like bonds and commodities.

Which is Better?

ETFs are probably the better product for most investors. In addition to no open market trading, mutual fund shares are less transparent and tax efficient. ETF shares disclose their holdings every day, so you know what’s in the fund at all times. Mutual funds only disclose holdings quarterly.

ETFs are also more tax efficient because redeeming shares isn’t technically considered “selling”. When mutual fund managers sell shares, it creates a taxable event that shareholders have to report. ETFs also distribute fewer capitals gains because no underlying assets must be sold when investors redeem shares.

ETFs are usually cheaper as well. For example, the SPY ETF has a net expense ratio of 0.09%, meaning you’d be charged $9 annually on a $10,000 investment. The Vanguard 500 mutual fund VFINX tracks the same stock index, but has a net expense ratio of 0.14% – more than 50% higher! These fees might seem inconsequential at first, but can cost you thousands over the long haul.

Final Thoughts

ETFs and mutual funds are the investment vehicles most people use to fund their 401ks and IRAs. Both products give investors exposure to a group of different stocks, bonds, or commodities. If you’re just beginning to build your retirement portfolio, index ETFs and mutual funds need to be a part of it. ETFs can be traded on the open market and offer more tax efficiency than mutual funds, so consider them first. But no matter which ones you choose, a portfolio filled with index funds is the most effective way to invest for a hands-off saver.

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