ETFs and funds: diversify with one trade
If you are looking for instant diversification, instead of picking individual companies, funds and ETFs may be the ideal choice. By bundling dozens or even hundreds of assets together, these investment vehicles allow you to spread your risk and build a well-rounded portfolio with just a single trade.
CONTENTS:
- What is an exchange-traded fund (ETF)
- What are mutual funds
- Mutual funds vs ETFs
- Assets under management (AUM)
- Expense ratios
What is an exchange-traded fund (ETF)
ETF is a collection of securities traded on an exchange in the same way as stocks. ETFs usually have low expense ratios and fewer brokerage commissions rather than when buying stocks separately. Unlike mutual funds, which only trade once a day after the market closes, you can buy and sell ETFs during market hours.
ETFs are structured to track a wide variety of assets, including commodities, market indices, crypto, and even specific investment strategies.
Passively managed ETFs usually track indices. Actively managed ETFs don't target an index. Instead, portfolio managers select and adjust the fund’s holdings based on the investment research and market outlook. That’s why they charge higher fees.
If you look for quality stocks for long-term growth dividend ETFs are a good choice. These ETFs pay dividends earned from underlying stocks.
ETFs typically have no minimum initial investment. You only need enough money to buy even one share, although some brokerages allow you to purchase fractional shares. Since ETFs trade like stocks, the minimum investment depends on the ETF's share price and your broker's trading rules.
In the United States, ETFs are subject to regulation and must be registered with the SEC.
ETF creation and redemption
Since ETFs trade like stocks, their prices fluctuate throughout the trading day. An ETF's market price may rise above its net asset value (NAV) due to strong demand or fall below NAV during sell-offs. To keep ETF prices aligned with their NAV, ETFs use a creation and redemption mechanism.
The creation and redemption process takes place in the primary market between the ETF issuer and authorized participants (APs), which are usually large financial institutions.
Creation process
When demand for an ETF increases and its shares begin trading above its NAV, an AP assembles a basket of the underlying securities the ETF tracks and delivers it to the issuer. In exchange, the issuer gives the AP a large block of ETF shares known as creation unit. The AP then sells the individual ETF shares on the stock exchange, increasing the supply and helping bring the ETF's market price closer to its NAV.
Redemption process
When there is an excess supply of ETF shares and they trade at a discount to NAV, an AP purchases ETF shares from the secondary market and returns them to the issuer. In return, the issuer delivers the underlying securities held by the ETF (redemption basket) to sell them in the market. Because the redeemed ETF shares are removed from circulation, the supply of ETF shares decreases and the price gets back toward NAV.
This mechanism helps to keep ETFs cheap, transparent, and tax-efficient.
What are mutual funds
A mutual fund is an investment fund that gathers money from multiple investors and uses them to invest in a diversified portfolio of securities, such as stocks, bonds, money market instruments. A fund manager researches opportunities and chooses investments on behalf of investors. As the value of the underlying assets rises or falls, investors share proportionally gains or losses.
Instead of buying individual stocks or bonds, you can purchase shares in a fund, becoming partial owner of all its holdings. The price of a mutual fund, known as net asset value (NAV), is calculated by dividing the total value of the fund’s holdings by the number of shares outstanding.
Same as ETFs, mutual funds allocate its assets across different sectors, industries, and companies according to its strategy. Investing in a single stock or bond can be risky, but a mutual fund reduces the risk through diversification.
Mutual funds can be broadly categorized into equity funds, bond funds, money market funds, index funds, balanced funds, and target-date funds. Each type has different risk and return characteristics designed to meet specific investment goals.
Many retail mutual funds require a minimum initial investment, typically ranging from $500 to $5,000. Institutional share classes and hedge funds often have much higher minimums, starting at $100,000 or more.
Mutual funds vs ETFs
Even though they are both investment funds that pool money from many investors to invest in a basket of assets, mutual funds and ETFs have certain differences.
Assets under management (AUM)
Assets under management (AUM) is a widely used metric in the investment industry that measures the total market value of assets managed by a mutual fund or an ETF. It represents the total amount of money invested in the fund.
AUM is calculated by summing the current market value of all portfolio holdings. For example, if a fund holds $7 million worth of Nvidia shares, $5 million in government bonds, and $2 million in cash, its AUM is $14 million.
AUM includes all capital that the fund manager can invest on behalf of clients. For instance, if you invest $30,000 in a mutual fund, that amount becomes part of the fund's total AUM. The manager can invest it according to the fund's stated objectives without seeking your approval for each transaction.
AUM is often tracked over time to measure growth and is frequently compared with competitors' AUM. A larger AUM is a sign of stability, liquidity, and investor confidence.
A fund's AUM typically increases through investment gains, capital appreciation, reinvested dividends, and new investor contributions. And visa versa, market losses and investor withdrawals reduce AUM.
Expense ratios
An expense ratio measures the annual cost of owning a mutual fund or ETF. It is expressed as a percentage of the fund's average net assets and is calculated by dividing the fund's annual operating expenses by its total assets.
Fund operating expenses include management fees, custody, accounting, auditing, legal, administrative, and other operating costs. The expense ratio doesn’t include brokerage commissions, trading costs, or other fees you may pay when buying or selling fund shares.
For example, if you invest $10,000 in an ETF with an expense ratio of 0.04%, the annual fund expenses amount to $4.
As the value of your investment grows, the amount you pay will also grow — which is why a fund’s expense ratio can significantly impact your returns over time.
ETFs generally have lower expense ratios than mutual funds. Historically, the median expense ratio has been about 0.56% for ETFs compared with 0.90% for mutual funds. ETF screener can help you compare and filter funds based on their expense ratios.
The bottom line
ETFs and investment funds are simply ways to package many different assets together. Instead of buying individual shares one by one, these vehicles allow you to access a wide variety of companies or bonds in a single transaction. While ETFs can be traded on exchanges throughout the day and traditional funds are priced at the market's close, both serve the same fundamental purpose: providing a convenient method to diversify a portfolio and spread out market exposure.
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