Lesson 7: Why invest in mutual funds and exchange-tradedfunds (ETFs)?
Explore the benefits and risks associated with investing in mutual funds and ETFs.
CIBC Investor's Edge
We’ve explored some of the benefits and challenges you’ll face when creating an investment portfolio of individual stocks and bonds. Many investors discover:
There’s some research involved — possibly extensive research if you’re considering many different stocks and bonds.
A small amount of money could make it difficult to properly diversify your portfolio.
If you’re investing in many stocks, you’ll probably want to stay informed about company-specific developments for each one, which can be time consuming. This information may sometimes be difficult to locate quickly and conveniently.
One possible alternative is to invest in mutual funds or ETFs. Here’s a bit of background on each one.
A mutual fund pools money from multiple investors to purchase a portfolio of stocks, bonds or other securities, depending on the fund’s strategy. It’s managed by a fund company with a team of professionals who make investment decisions on behalf of the fund's investors. Mutual funds typically charge an annual management fee and may also have a sales charge, which will reduce the overall return for investors.
An ETF, or exchange-traded fund, is similar to a mutual fund in that it also pools money from multiple investors to purchase a portfolio of stocks, bonds or other securities, depending on the ETF’s strategy. However, unlike mutual funds, ETFs are traded on stock exchanges and can be bought and sold like individual stocks. Passively managed ETFs often have lower management fees than mutual funds and may have a more tax-efficient structure.
Let’s compare and contrast
Here are some of the advantages of investing in mutual funds or ETFs versus individual stocks or other assets:
Diversification: Mutual funds and ETFs can give you exposure to a wide range of assets in one fund. If you select a balanced fund or other multi-asset type fund, this will hold assets from several different asset classes, depending on the fund’s strategy and objectives. This diversification can potentially reduce your overall risk. There are a wide variety of strategies available to potentially suit your individual diversification needs.
Professional management: Mutual funds and ETFs are managed by professional fund managers who have the expertise and resources to research and select investments on your behalf, depending on the strategy. They also keep track of developments in their holdings and take action when they consider it necessary for actively managed strategies. Depending on the current market conditions and the particular investment, this can be a time-consuming job for an individual. For some smaller stocks or international stocks, information might be hard to obtain, especially in a timely way. While many investors enjoy this research, others find it overwhelming.
Lower costs: Compared to buying individual stocks, buying equity mutual funds and equity ETFs can be a cost-effective way to invest in a number of stocks at the same time. You’ll buy a basket of stocks in one purchase, for one fee. However, you may decide to spread your mutual fund or ETF purchases over time, in which case you may pay a separate commission each time.
Here are some disadvantages of an investment in mutual funds or ETFs versus individual stocks or bonds:
Lack of control: With a mutual fund or actively managed ETF, you’re relying on the fund manager to make investment decisions on your behalf and you have no control over which specific stocks or bonds you own.
Limited customization: Mutual funds and ETFs generally follow a specific investment strategy, so you may not be able to tailor your portfolio to your specific investment goals and risk tolerance. However, there’s a wide range of mutual funds and ETFs available and you’ll likely be able to find something suitable for your situation.
Potentially higher returns with individual stocks: By carefully researching and selecting individual stocks, you may be able to achieve higher returns than you would with a mutual fund or ETF. You’ll also avoid the management fees and sales charges that can come with those products. These fees are charged regardless of whether the fund’s return is positive or negative in a given period.
The best approach for you will depend on your investment goals, risk tolerance and personal preferences.
Fund performance versus market index performance
Many fund managers struggle to beat or match the performance of market indexes.
This is due to a number of factors, including:
Costs: Fund managers charge management fees, which can eat into investment returns. Fees are charged regardless of whether the fund return is positive or negative for a given period.
Market efficiency: The stock market is highly efficient, making it difficult for fund managers to consistently beat the market by picking individual stocks.
The human factor: Fund managers, like all investors, can make errors in judgement that result in poor investment decisions or trades executed at the wrong time.
Despite these challenges, many investors still choose to invest in mutual funds and actively managed ETFs because they provide professional management and diversification. For some investors, these benefits outweigh the costs and potential underperformance compared to market indexes.
In fact, some actively managed funds may outperform market indexes under certain market conditions or for certain market sectors. This is why it's important to carefully research and consider all options before making an investment decision.