The two most common ways to invest in stocks are to buy stocks of individual companies or to invest in a fund. As with most things related to finance, there are pros and cons to each. Here are three things to know about mutual funds before you decide to invest in them.
Mutual funds vs exchange traded funds
Mutual funds and exchange traded funds (ETFs) are similar in that they are both funds that contain a mix of different companies, but there are some fundamental differences. For starters, ETFs are traded like individual stocks; you can use your brokerage account to buy shares of an ETF just like you would a sole proprietorship. ETF prices change throughout the day and as long as the stock market is open, 9:30 a.m. to 4:00 p.m. EST, you can buy stocks.
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Mutual funds, on the other hand, can only be bought at the end of the trading day at a fixed price, usually the net asset value (NAV) of the fund. The net asset value of a mutual fund is calculated by taking its total assets and subtracting all of its liabilities. Because these numbers change frequently throughout the day, mutual funds choose to calculate NAV once per day. With individual stocks and index funds, you can buy a fixed amount of stocks, but you have to invest a fixed amount in mutual funds, and they usually have a minimum investment amount.
The two types of mutual funds
There are two types of mutual funds: open funds and closed funds. Open-end funds are by far the most common type of mutual fund and are purchased directly from an investment firm, such as Vanguard or BlackRock. Investment companies can issue as many units of UCITS with variable capital as they wish.
Closed-end funds only issue a specific number of shares, regardless of demand. Unlike open-end funds, which are priced based on their net asset value, closed-end funds are typically sold for less than the fund’s net asset value and determined by supply and demand.
The cost structure
Unlike index funds which are passively managed and aim to reflect a defined index, mutual funds are actively managed by professional investors and aim to beat the market. Because they are actively managed, they tend to be more expensive than index funds. The main fees with mutual funds are their expense ratio, which is a percentage charged annually based on the value of your investment.
For example, if you had $ 100,000 in a mutual fund with an expense ratio of 2%, you would pay $ 2,000 in fees. The fees vary by fund, but they are one of the most important things to consider when deciding whether or not to invest in a fund. High fees eat away at your returns, and there is no guarantee that a fund with higher fees will generate higher returns.
What may seem like a small difference in fees between funds can end up being worth a lot over time. If you put $ 20,000 into two funds that each earn 8% per annum but have a fee of 1% and 2%, respectively, the difference between the two funds would be around $ 13,250 after 20 years.
Consider your investment strategy
Whether or not investing in mutual funds is right for you ultimately depends on your investment strategy. If you prefer a bottom-up investment approach and want to focus on individual businesses, mutual funds probably won’t be your choice. If you’re looking for a way to get instant diversification and don’t mind the probably higher fees, mutual funds are a good option to consider. Ultimately, do what makes you comfortable and promotes your financial goals.
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Foolish contributor Stefon Walters does not hold any financial positions in the companies mentioned.