The two most common ways to invest in stocks are by purchasing shares in individual companies or investing in a fund. As with most finance-related things, there are pros and cons to each. Here are three things to know about mutual funds before deciding 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 containing a mix of different companies, but there are fundamental differences. To begin, ETFs are traded like individual stocks; you can use your brokerage account to buy shares of an ETF just like you would an individual company. ETF prices change throughout the day, and as long as the stock market is open — which is from 9:30 a.m. to 4 p.m. EST — you can purchase shares.
Mutual funds, on the other hand, can only be purchased at the end of the trading day at a set price, usually the fund’s net asset value (NAV). A mutual fund’s NAV is calculated by taking its total assets and subtracting all of its liabilities. Because these figures frequently change throughout the day, mutual funds choose to calculate the NAV once a day. With individual stocks and index funds, you can purchase a set amount of shares, but you must invest a set dollar amount with mutual funds, and they usually have a minimum investment amount.
The two types of mutual funds
There are two types of mutual funds: open-ended funds and closed-end funds. Open-ended funds are by far the most common type of mutual funds and are purchased directly from an investment company, such as Vanguard or BlackRock. Investment companies can issue as many open-ended mutual fund shares as they want.
Closed-end funds only issue a set number of shares, regardless of the demand. Unlike open-ended funds, whose prices are based on their NAV, closed-end funds are generally sold at a discount to the fund’s NAV and determined by supply and demand.
Unlike index funds that are passively managed and aim to mirror a set index, mutual funds are actively managed by professional investors and aim to beat the market. Because they’re actively managed, they tend to be costlier than index funds. The primary fee with mutual funds is its expense ratio, which is a percentage charged annually based on the value of your investment.
For example, if you have $100,000 in a mutual fund with an expense ratio of 2%, you’d pay $2,000 in fees. Fees vary by fund, but they’re one of the most important aspects to consider when deciding whether or not you want to invest in a fund. High fees eat away at your returns, and there’s 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 returned 8% annually but had a 1% and 2% fee, 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 comes down to your investment strategy. If you prefer a bottom-up investing approach and want to focus on individual companies, mutual funds will likely not be your go-to. If you want a way to achieve instant diversification and don’t mind the likely higher fees, mutual funds are a good option to consider. Ultimately, do what makes you comfortable and furthers your financial goals.
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Fool contributor Stefon Walters holds no financial position in any companies mentioned.