Within this article of Non-Pharm Finance, I will break down different types of funds to help new traders. Since there are many similarities and differences, it’s important for any investor to understand the different types of funds to determine which works best for them. Deciding on which is right for you depends on numerous factors and your own personal preferences.
Mutual Funds – Mutual funds are managed and rebalanced by fund managers. Their work costs money, leading to higher fees you pay to invest in the fund. This is beneficial for those who want to push their investing into someone else’s hands. Generally, top performing mutual funds have returns higher than the market, which is attractive to most investors. However, there are times when this attracts more investors to the above-average performing mutual fund. If the assets grow to an unmanageable amount, it may lead to below-average results.
Index Funds & Exchange-Traded Funds (ETFs)
Index funds and exchange-traded funds (ETFs) mimic the performance of different market indexes such as the S&P 500. They are attractive because they offer diversification of a mutual fund and have lower expense ratios compared to the actively managed mutual funds.
Index Fund – As stated above, index funds are portfolios built to mimic the performance of market indexes. You buy shares of an index fund, and the value of your shares rise and fall with the value of that index. The difficulty with index funds are that they often have initial investment minimums of thousands of dollars. This makes it difficult for some investors to buy shares of index funds. Another problem is that their prices are set at the end of the trading day, regardless of what time of day you buy a share. This impacts buying and selling shares.
Exchange-Trade Fund (ETF) – ETFs trade like a stock, but they offer you the diversification. Like index funds, you can use ETFs to invest in a variety of asset classes, like stocks, bonds, and commodities. However, unlike index funds, there are no investment minimums. When you buy a share of an ETF, it’s treated like you bought a share of a stock. You can make trades during market hours to maximize profit or minimize loss, while index funds are priced at the end of the trading day. I personally trade ETFs over mutual funds or index funds.
*PillPicks Tip – There are many different ETFs that track the same index. Do your research and pick ETFs that track the market index closely with the lowest expense ratios so you have the highest returns possible*
S&P 500 – American stock market index based on the market capitalization of 500 large companies. Wealthfront currently invests in the SCHB and VTI.
Leveraged Exchange Traded Funds (ETFs) – A leveraged exchange-traded fund (ETF) is an ETF that uses financial derivatives and debt to amplify the returns of an index. While a traditional ETF typically tracks an index on a one-to-one basis, a leveraged ETF may aim for a 2:1 or 3:1 ratio. There are also inverse ETFs that rise if the index is falling. This allows investors to profit from a bearish market or market declines. I personally have day traded the leveraged ETFs below. Beware, since these leveraged ETFs are 3 fold the index they track, they come with great risk and shouldn’t be used as long-term investments. I recommend paper-trading before taking a position in any leveraged ETF.
|Index Tracked||3x ETF||Inverse 3x ETF|
Choosing between the different funds are a matter of selecting the correct tool for the job. The tools are similar, but they have significant differences in application and usage.
An investor has the option of using all the different types of funds. You might choose to use a mutual fund as a core holding and add ETFs that invest in sectors to further diversify. An investor can decide to only use one of the types of funds to diversify. Do your due diligence, research and determine what is the best strategy for your financial goal.
If you haven’t read Non-Pharm Finance: Part I, please follow the link below. I provide my recommendation on how to get started investing and making money while you learn the market.