Funds & ETFs
One Investment, Many Securities
Investment funds allow investors to gain exposure to a collection of securities through a single investment vehicle. Instead of selecting and purchasing every stock, bond, or other asset individually, investors can buy shares of a fund that holds a portfolio on their behalf.
Mutual funds and exchange-traded funds, commonly known as ETFs, are two widely used structures. Both can provide access to diversified portfolios, specific markets, industries, asset classes, or investment strategies, but they differ in how they are traded, priced, and managed.
- Access to diversified portfolios
- Exposure to multiple asset classes
- Active and passive strategies
- Professional portfolio management
- Broad or specialized market exposure
- Different cost and trading structures
How Investment Funds Work
An investment fund pools money from multiple investors and uses that capital to purchase a portfolio of securities or other assets according to a defined investment objective. Investors own shares or units of the fund rather than directly owning each underlying asset in the portfolio.
A fund might hold hundreds or even thousands of securities. This structure can make it easier to spread investment exposure across companies, industries, countries, bond issuers, or other markets without managing each position separately.
The actual holdings depend on the fund's mandate. Some funds attempt to represent an entire market, while others concentrate on a particular sector, region, asset class, investment style, or strategy.
What Is an ETF?
An exchange-traded fund is an investment fund whose shares trade on an exchange during the trading day. Investors can generally buy and sell ETF shares through a brokerage account in much the same way they trade individual stocks.
ETFs can track broad stock or bond markets, individual sectors, commodities, investment themes, geographic regions, or more specialized strategies. Some are designed to follow an index, while others are actively managed.
Because ETF shares trade throughout the day, their market price can change continuously while the market is open.
What Is a Mutual Fund?
A mutual fund also pools investor capital into a professionally managed portfolio. Unlike ETFs, traditional mutual fund shares generally do not trade continuously on a stock exchange during the day.
Transactions are typically processed based on the fund's net asset value calculated after the applicable market close. Depending on the fund, it may follow an index or use an active investment strategy managed by a portfolio management team.
ETFs vs Mutual Funds
ETFs and mutual funds can provide similar underlying investment exposure, but their structures and trading mechanics differ. Neither structure is automatically superior in every situation.
| Feature | ETFs | Mutual Funds |
|---|---|---|
| Trading | Trade on exchanges during the market day | Typically transact at calculated NAV |
| Pricing | Market price changes throughout the day | Generally priced using end-of-day NAV |
| Management | Can be passive or actively managed | Can be passive or actively managed |
| Portfolio Exposure | Can range from broad markets to specialized strategies | Can range from broad markets to specialized strategies |
| Trading Considerations | May involve bid-ask spreads and brokerage considerations | May involve minimums, sales charges, or other fund-specific terms |
Net Asset Value (NAV)
Net asset value represents the value of a fund's assets minus its liabilities, generally expressed on a per-share basis. NAV provides an important reference point for understanding the value of the portfolio held by a fund.
For traditional mutual funds, NAV is normally central to the price at which investors purchase or redeem shares. ETFs operate differently because their shares trade in the market throughout the day and can therefore trade slightly above or below their NAV.
Market mechanisms involving authorized participants and the creation and redemption of ETF shares are designed to help keep an ETF's market price relatively close to the value of its underlying holdings, although differences can still occur.
Index Funds and Passive Investing
An index fund seeks to track the performance of a specified market index rather than selecting securities primarily through discretionary investment decisions. Index funds can be structured as either mutual funds or ETFs.
For example, a broad-market index fund may hold shares across hundreds of companies in an attempt to provide exposure similar to the index it follows. Other index funds may focus on bonds, industries, geographic regions, company sizes, or investment factors.
Passive strategies generally aim to replicate or closely follow their benchmark rather than outperform it through frequent security selection.
Actively Managed Funds
Actively managed funds use portfolio managers or investment teams to make decisions about which securities to buy, hold, or sell. Their objective may be to outperform a benchmark, manage particular risks, generate income, or pursue another defined investment strategy.
Active management provides greater flexibility in security selection but can also involve higher management costs, increased portfolio turnover, and the possibility that the fund will underperform its benchmark.
Common Types of Funds & ETFs
The fund market covers a wide range of asset classes and strategies. Understanding what a fund actually owns is more important than relying only on its name or category.
Stock Funds
Stock funds invest primarily in equities. They may provide broad exposure to the stock market or concentrate on specific sectors, industries, company sizes, investment styles, or geographic regions.
Bond Funds
Bond funds invest in government, corporate, municipal, or other fixed-income securities. Portfolios can differ significantly in maturity, duration, credit quality, and interest-rate sensitivity.
Balanced and Multi-Asset Funds
Balanced and multi-asset funds combine more than one asset class within the same portfolio. A fund might hold stocks, bonds, cash instruments, or other investments according to a predetermined or actively managed allocation.
Sector and Industry Funds
Sector funds concentrate on particular areas of the economy, such as technology, financial services, healthcare, energy, or industrial companies. This can provide targeted exposure but may also create greater concentration risk than a broad-market portfolio.
International and Global Funds
International funds provide exposure to markets outside an investor's home country, while global funds may invest across both domestic and international markets.
These funds can expand geographic diversification but may also introduce currency, political, regulatory, and market-specific risks.
Commodity and Real Asset Funds
Some funds provide exposure to commodities, precious metals, energy markets, real estate, infrastructure, or other real assets. The method used to obtain that exposure can vary, including ownership of securities, physical assets, derivatives, or futures contracts.
Thematic Funds
Thematic funds focus on a particular long-term trend or investment idea rather than a traditional market sector. Examples may include technological change, automation, infrastructure, cybersecurity, clean energy, or demographic trends.
Thematic portfolios can be highly concentrated and their holdings may overlap with investments already present elsewhere in a portfolio.
Understanding Fund Costs
Investment funds have operating expenses, and those costs can affect investor returns over time. One of the most common measures used to compare ongoing fund costs is the expense ratio.
Expense Ratio
The expense ratio represents certain annual operating expenses of a fund as a percentage of its assets. These costs are generally deducted from fund assets rather than appearing as a separate recurring bill to the investor.
Even relatively small differences in annual expenses can become meaningful over long investment periods because costs reduce the amount of capital that remains invested and able to compound.
Other Costs
The expense ratio does not necessarily represent every cost associated with investing in a fund. Depending on the investment vehicle and account, other considerations can include trading commissions, bid-ask spreads, sales charges, transaction fees, taxes, and other expenses.
ETF Liquidity and Trading
Because ETFs trade on exchanges, investors should understand both the liquidity of the ETF shares and the liquidity of the securities held inside the fund.
Frequently traded ETFs may have relatively narrow differences between the price buyers are willing to pay and the price sellers are willing to accept. This difference is known as the bid-ask spread.
During periods of market stress or when an ETF holds less-liquid assets, trading conditions can become less favorable and spreads may widen.
Tracking Error
An index fund seeks to follow its benchmark, but its performance will not necessarily match the index exactly. The difference between the fund's results and the performance of its benchmark is commonly discussed in terms of tracking difference or tracking error.
Fund expenses, trading costs, portfolio construction, cash holdings, taxes, and the methods used to replicate an index can all contribute to differences between the fund and its benchmark.
Diversification Through Funds
One of the major reasons investors use funds is the ability to obtain exposure to many securities through a single investment. A broad stock market fund, for example, may provide exposure to hundreds or thousands of companies.
However, owning a fund does not automatically mean that a portfolio is well diversified. A fund can be concentrated in one sector, country, asset class, investment style, or group of large holdings.
Investors may therefore need to examine what a fund actually owns and how those holdings overlap with other investments in the portfolio.
Risks of Funds & ETFs
Funds can simplify diversification and portfolio management, but they remain exposed to the risks of their underlying investments. A fund that owns stocks can decline when equity markets fall, while a bond fund can lose value because of changes in interest rates or credit conditions.
- Market risk
- Concentration risk
- Interest-rate and credit risk
- Liquidity risk
- Tracking risk
- Strategy and management risk
The Role of Funds in a Portfolio
Funds and ETFs can be used as core portfolio holdings or as tools for obtaining more specialized exposure. A broad-market fund might form part of a portfolio's foundation, while other funds may be used to add exposure to particular asset classes, sectors, regions, or investment strategies.
The appropriate role depends on what the fund owns, how it is managed, its costs, its risks, and how it interacts with the rest of the portfolio. Multiple funds can sometimes hold many of the same securities, creating more overlap than their different names might suggest.
Evaluating a fund therefore involves looking beyond recent performance and considering its underlying portfolio, investment objective, benchmark, fees, management approach, and risk characteristics.
What to Consider When Comparing Funds
Two funds in the same general category can differ considerably. Comparing their investment objectives and portfolio characteristics can provide a clearer picture than comparing historical returns alone.
- Investment objective
- Underlying holdings
- Benchmark or strategy
- Expense ratio
- Active or passive management
- Diversification and concentration
- Liquidity and trading structure
- Risk characteristics