Understanding Mutual Funds and ETFs

Rather than investing in an individual stock or bond, many investors choose to invest in mutual funds or exchange-traded funds (ETFs). Mutual funds and ETFs provide automatic diversification, so you can be invested in several companies or industries without having to choose individual stocks. They're also professionally managed, so you don't have to spend time following the day-to-day happenings in the stock market.

Understanding mutual funds

A mutual fund is a company that pools money from many investors and invests in a broad range of securities, depending on the goal of the fund. Just like you, a mutual fund can choose to buy stock in companies, invest in bonds or cash, or select a combination. With a mutual fund, your order to buy or sell shares is processed at the end of the day and, unless there is a sales load or transaction fee, there is no cost for the trade.

Investing in mutual funds might be a good choice if you:

• Seek active management—While many ETFs passively track an index, mutual fund managers of actively managed funds typically aim to beat a benchmark index through strategic stock selection. (Index funds, on the other hand, are not actively managed. Rather, they're automatically invested to track an index.)
   
• Look for unique investing strategies—Mutual funds may follow unique investing strategies, such as actively managed target-date funds.
   
• Want to limit fees—Look for mutual funds that have low expenses, do not charge transaction fees, or sales commissions.

Understanding ETFs

Many ETFs track an index, or a basket of assets such as an index fund, and are traded on a public stock exchange. With an ETF, you can buy or sell shares at any time during the trading day (like a stock); in some cases, a commission for each purchase or sale is charged. ETF shares typically have higher liquidity than mutual fund shares.

Investing in ETFs might be a good choice if you:

• Trade actively—Shareholders can sell short, buy on margin, and set stop or limit orders.
   
• Want niche exposure—Some ETFs focus on specific industries or commodities.
   
• Are tax-sensitive—Shareholders are not taxed on capital gains from sales inside the fund.

Types of funds

There are many types of funds, with varying investment styles. And each fund carries a different level of risk and return. Here are the main types of funds:

• Index funds are good options for both first-time and seasoned investors. Each of these funds comprises a portfolio of stocks that attempts to mimic the performance of a specific index, such as the S&P 500® Index or the Wilshire 5000 Index. In addition to providing diversification, index funds can be attractive because of their simplicity and relatively low fees.
   
• Actively managed funds have managers who invest with hopes of beating a benchmark. Performance and fees vary greatly depending on the type of fund and its manager, so you have to be sure to choose carefully.
   
• Stock (or equity) funds invest in U.S. or foreign stocks. There are many different stock funds, with a wide variety of investment areas of focus and risk levels. (Some stock funds are also index funds, while other are actively managed.)
   
• Bond funds typically invest in corporate, municipal, or government bonds. They are further classified by whether they are taxable or nontaxable.¹ (Some bond funds are also index funds, while other are actively managed.)
   
• Money market funds generally invest in cash equivalents such as short term high quality debt such as U.S. Treasury bills and CDs. They are lower-risk investments compared to stock or bond funds and tend to offer better returns than savings accounts, but they are not insured by the FDIC.
   
• Blended or balanced funds invest in stocks, bonds, and cash with the goal of achieving both investment growth and stability. (These funds also can be index funds or actively managed.)
   
• Target-date or life-cycle funds are types of balanced mutual funds or ETFs that shift asset allocation as your target date for needing the money draws near. These may be a great option for people who want a single investment and don't want to have to rebalance their portfolios frequently. They may also be a good choice for retirement investing.

Tips for choosing the right fund

Here are some things to consider:

1. Start with broad-based funds. This will help to improve diversification.
    
2. Consider no-load funds with no transaction fees. You don't want to pay sales charges if you don't have to. Watch out for other fees such as operating expenses. High fees can really eat into your returns.
    
3. Taxes can have a big impact on returns. For instance, funds right for a tax-deferred account like an IRA may not be right for a taxable account. Learn more about tax-smart investing.

Not all funds offer broad-based diversification. For example, some funds invest in a single industry or sector. Keep this in mind as you choose funds.