Mutual Fund, Index Fund, ETF. Please explain?
Recently I had a nice email from a subscriber asking the following:
“Can you please explain the types of funds there are and what they mean. E.g. Exchange Traded Funds, Managed Funds, Mutual Funds and any other types there are. And maybe a little bit about the sharemarket. I find it a bit confusing and have so much to learn!”
Such a simple question but oh so complex once you start to drill down into it.
We emailed back and forth a bit and she revealed that through grit and determination she cleared all the debt she and her husband had and are now free and clear to invest so is on a steep learning curve to work stuff out. Can I please get a round of applause here! As she begins her investing journey the mumbo jumbo is confusing her. Yep, feeling your pain my friend, feeling your pain, been there done that! And still doing it.
Just the other day I was having a conversation with a gentleman far more intelligent than myself and he was asking me “why do you bother buying SmartShares Ruth, why don’t I just buy on the stock exchange directly” as he has been doing since the 1970’s. And my answer was that the stock exchange has, in my mind, an image problem:
It’s too fecking complicated for a newbie investor.
When I started my journey of becoming an investor the hardest thing was picking what to buy when I had ONE MILLION options to choose from. And I knew I was being marketed to by a lot of SLICK banks and institutions and learning all of their lingo was TOO CONFUSING.
In my case, after a lot of Googling the facts, figures and terminology, making the decision to buy SmartShares went something like this: “click, click, click, done”. Now I am an investor. I realised I didn’t need to learn an entirely new field of study, I just needed to learn enough to get involved.
So, as concisely as possible I’m going to try to answer the above questions today. When you have finished reading this I want you to then go and do something far more productive with your time. In researching this I was surprised at how what appeared the most simple question, was actually the hardest to answer as I chugged my way through wordy, dull explanations of each type of fund. Now, if I was in Medical School I would pay close attention to the detail because it could literally be the difference between life and death one day, but this stuff is not. This stuff gets complicated quickly and CONFUSING so my challenge today is to make it less so.
In simple speak:
Exchange Traded Funds, or ETFs, are a subset of Index Funds.
Index Funds are a subset of Mutual Funds.
WHAT IS A MUTUAL FUND?
It pools the money of many individual investors so that even if you have only a small amount of money you can get involved in the fund.
Your fund manager (a real live person) researches the heck out of stuff and selects the companies that will make up that fund with say different percentages of stocks 50%, bonds 30% and cash 20% (or a mixture of all sorts of other securities etc).
You pick the type of fund that tickles your fancy e.g. New Zealand share fund, International share fund, International widget fund or what have you and you buy and sell it through your fund manager.
I may put in $5,000, you may put in $10,000, Mary might put in $15,000. Each of us are allocated a proportion of the fund relative to what we have invested and we each get our share of the profits (or losses) of that fund in proportion to what we have invested.
There are a massive amount of funds you can buy into! If you can dream up a fund, a fund manager has probably created it already… A fund can literally be made up with hundreds of companies if that is what the fund manager chooses.
Mutual Funds are diversified so you can expose yourself to many companies or sectors in a particular market, which is better than just picking an individual company to invest in because you spread your risk. These fund managers spend their time analysing the performance of the fund and choosing what to include in it and what to leave out. They need to live and breathe it so they can predict what is going to happen next. They are trying to beat the market and provide better than average returns to their investors. These are considered actively managed funds.
As an investor, you pay a fee for this service because all of the people needed to run a fund need to be PAID. And they want to be paid well. There are a myriad of fees you can be charged. Humans have proved themselves to be fallible when they pick how to make up these funds. Past performance is NOT an indicator of future success.
WHAT IS AN INDEX FUND?
It is a type of Mutual Fund that is designed to track a whole Index like the NZ Top 50 companies.
You are diversified, instead of buying one company, you buy a small piece of each of the 50 companies that make up that whole Index.
They are a more passive investment - fund managers are not required to pick which companies are involved in the Index, all of them are. They just need to make sure that the fund mimics the Index. If Bella’s Cakes is the all time top performer and makes up 20% of that Index, then the fund will match that, right down to the bottom performer Penelope’s Pizza that only makes up 1% of the Index.
Index Funds have been proven to outperform actively managed funds over time and they also have tax advantages.
They are much cheaper to administer because they just track an Index, they don’t require analysts to pick and choose what goes into it.
An Index Fund can be traded throughout the day like a normal single stock.
WHAT IS AN EXCHANGE TRADED FUND OR ETF?
To make up an ETF the manager of the fund will buy groups of shares for a particular sector eg. NZ Top 10 and pool all of these shares together into one big group and list THAT group on the stock market.
It is an investment fund traded on the stock exchange and you can buy and sell it just like individual shares and the price fluctuates up and down over time with supply and demand.
You can buy direct and use a share broker to sell and you can invest in multiple companies, or bonds or what have you, with ONE transaction.
They also buy a slice of each company in proportion to the Index, biggest to smallest and you can see exactly which companies make up the ETF you are involved in.
An ETF is designed to track the whole Index and the fund selection process is mechanical. So if the Top 10 companies in NZ go up 2% then the ETF fund goes up 2%. If number 10 company underperforms it is replaced by number 11 company on the index.
They pay out the dividends that the companies who make up the ETF produce.
They have very low FEES because computers don’t ask to be paid and there are far fewer humans involved.
Watch this quick video where someone else has a go at explaining it: What's the Difference Between an Index Fund, an ETF, and a Mutual Fund?
Finally, to explain a “little bit about the sharemarket” is akin to explaining a little bit about how the internet works. The world of share markets is massive and they have their own glossary to describe what they do and all the terms that they use.
I took this straight from Investopedia: The stock market refers to the collection of markets and exchanges where the issuing and trading of equities (stocks of publicly held companies), bonds and other sorts of securities takes place, either through formal exchanges or over-the-counter markets. Also known as the equity market, the stock market is one of the most vital components of a free-market economy, as it provides companies with access to capital in exchange for giving investors a slice of ownership.
To make a more straightforward comparison between the internet and the sharemarket I would just like to say thank goodness for Google and thank goodness for ETFs. I’m unlikely to ever fully understand how the internet OR the sharemarket actually works but I have worked out that I DON’T REALLY NEED TO KNOW; you and I don’t need to learn it all! As I said to my friend the other day, I just know enough to be dangerous. I have taken the simple path and that is to just find a low cost Index Fund, which also happens to be called an ETF. I use SmartShares, you may prefer SuperLife, you may find another provider entirely. But just stick to your day job, whatever it is, and keep your investing life as uncomplicated as you possibly can.
I hope that was not the most boring post I have ever written. I suspect it might have been. I’m off out for a run to clear my head.