Whether you’re a committed DIY investor or happy to work closely with an experienced financial advisor, your investment portfolio probably contains a mix of multi-equity funds, such as ETFs, index funds, and actively managed mutual funds. But how much do you really know about each type of instrument?
According to San Francisco wealth management professional Daniella Rand, it’s crucial for investors to understand the distinctions between these three common fund types. Each has its own unique set of attributes, advantages, and disadvantages; what’s appropriate for one investor may not be suitable for another. Here’s what you should know about each — before making any investing decisions.
What Are ETFs?
An exchange-traded fund, or ETF, is a publicly traded basket of equities. Unlike mutual funds, ETFs trade like stocks: sales are recorded during market open hours, although some ETFs have relatively low outstanding share counts and are therefore illiquid relative to blue-chip equities.
ETFs are generally designed to achieve specific investing objectives, often tracking the performance of an underlying benchmark. These benchmarks can be quite basic; some ETFs simply track the value of major stock indices. ETFs that track stock indices’ value are known as index funds.
Others are more exotic or complex; inverse ETFs, for instance, are designed to move opposite underlying benchmarks, such that their market values rise when benchmark values fall.
Because they’re traded on exchanges during open market hours, ETFs’ net asset values rise and fall in real time, based on the cumulative market value of their components. By contrast, mutual funds’ net asset values change just once daily, at the conclusion of market trading.
What Are Actively Managed Funds?
Actively managed mutual funds are not traded on major exchanges. However, their components are closely calibrated to achieve specific objectives or goals that may be difficult or impossible for passively managed funds to achieve. Before investing in an actively managed fund, consult the fund’s prospectus and research reports from reputable third parties.
Drawbacks of Passive Funds
Most ETFs and all index funds are passively managed, meaning their components aren’t actively rebalanced or otherwise altered on a day-to-day basis. Indeed, an index fund’s composition likely won’t change at all between periodic rebalances, and new components are only added when the composition of the underlying index changes. (Indices like the S&P500 add and delete components regularly.)
Because they’re not managed on a day-to-day basis, passive funds can’t take advantage of short-term opportunities or optimize performance to the same extent that actively managed funds can. While their management fees and expenses tend to be lower than actively managed funds’, competently managed mutual funds’ performance may justify higher fees.
Don’t Be Afraid to Ask for Help
You don’t need a finance degree to grasp the basic differences between ETFs, index funds, and actively managed funds. At the same time, you probably don’t have the bandwidth to really dive into the details of each instrument. You’ve got your own life to live, your own career to manage, your own family to support.
The good news: You can always turn to an experienced financial advisor for answers to complicated investing questions — even if you’ve been managing your investments on your own to this point. As you get to work building or rebalancing your investment portfolio, don’t be afraid to turn to your current or future advisor for help and ensure they earn their keep.