Mutual Funds and ETFs: Simple Means of Diversification

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Mutual funds and exchange-traded funds (ETFs) are among the most common financial instruments for investors seeking diversification. Many investors are familiar with mutual funds through their 401(k) plans and other retirement accounts, which typically offer a selection of such funds as investment options. However, fewer know about the benefits offered by their ETF cousins, which have seen their popularity explode in recent years.

Over 115 million individual investors owned US mutual funds alone at the close of 2022, according to the Investment Company Institute. Their popularity stems from their utility as simple and effective tools to grow household savings. They provide exposure to a diversified portfolio of assets in a single investment, allowing investors to focus on their lives and leave the stock picking to professionals. And while these funds are designed to be simple and to help everyday investors access the markets, there are some important details to understand to ensure your investments are aligned with your goals.

What is a mutual fund?
A mutual fund is an investment company that pools money from a group of participants to collectively buy an entire portfolio of securities, such as stocks or bonds. These become the fund’s underlying investments, and its performance is based on their performance. Your purchase lets you share in the profits of these investments, just as any shareholder or debtholder would. However, rather than selecting individual stocks or bonds yourself, professional portfolio managers are employed to regularly evaluate market conditions for potential opportunities. For many investors, this luxury and convenience is well worth the expense of investing in the fund.

Even those interested in trading individual securities might still consider incorporating mutual funds into their portfolio. They democratize diversification, boasting lower barriers to entry for everyday investors seeking a well-rounded allocation. Mutual fund investors also avoid the transaction fees associated with trading hundreds of securities. Choosing a complement of funds and individual holdings can be an effective strategy to build out a diversified portfolio that provides a combination of growth and stability matching your objectives.

Shares of mutual funds are not traded on the open market and cannot be watched in the same manner as stocks. They are designed to accommodate new investors at any time by issuing new shares on demand. Likewise, they retire shares as investors decide to exit the fund. Fund shares are priced once at the end of each trading day at their Net Asset Value, which accounts for the changing number of outstanding shares. Mutual funds should therefore be evaluated based on their past performance, rather than comparing “prices.” However, an investment professional will remind you that past performance is not indicative of future results.

RELATED: Read how to assess your 2024 financial goals.

How do investors profit?
A fund’s managers choose when to distribute its investments’ profits to shareholders. When the investments pay dividends or interest, the fund makes an income distribution. When the fund managers decide to sell an underlying investment for more than they paid for it, they pay out the profit in the form of a capital gains distribution. Of course, investors in the fund can also earn a profit when the fund shares themselves increase in value.

What is the cost of owning a fund?
An expense ratio is used to represent the costs of owning a mutual fund. Instead of charging fees on your account, the expenses are taken from the fund’s total value and investors receive a lower return. With an abundance of funds and fund companies to choose from, it is critical to compare expense ratios to maximize potential returns and minimize their impact on your portfolio.

What is an ETF?
Exchange-traded funds, or ETFs, are very similar to mutual funds. They are also pooled investment vehicles that offer access to a portfolio of assets in a single investment. Unlike mutual funds and as their name suggests, ETFs are traded on an exchange like stocks. This means that their prices fluctuate throughout the trading day and stray from their Net Asset Value.

Importantly, ETFs can offer tax advantages over mutual funds. They allow the owner to decide when to incur a capital gain liability by selling shares. In contrast, mutual fund investors do not have control over the timing and frequency of capital gains distributions thrown off by the fund.

Millions of investors have chosen mutual funds and ETFs as easy and cost-efficient methods of diversifying their portfolios. To learn more and to discuss your investment goals in detail, please contact our experienced financial advisors at 412-630-6000 or visit our website.

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References:
https://investor.vanguard.com/investor-resources-education/education/expense-ratio
https://www.blackrock.com/us/individual/education/mutual-funds#:~:text=What%20are%20the%20potential%20benefits%20of%20investing%20in%20mutual%20funds%3F&text=Because%20mutual%20funds%20can%20invest,way%20to%20diversify%20their%20portfolio.&text=Mutual%20funds%20offer%20an%20affordable,fees%20for%20each%20stock%20held
https://www.finra.org/investors/insights/etf-vs-mutual-fund
https://investor.vanguard.com/investor-resources-education/mutual-funds/what-is-a-mutual-fund
https://www.schwab.com/mutual-funds/understand-mutual-funds3
https://www.sec.gov/answers/mfinvco.htm
2023 Investment Company Fact Book, Investment Company Institute

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