What Is a Stock?

A stock (also known as equity) is a security that represents the ownership of a fraction of a corporation. This entitles the owner of the stock to a proportion of the corporation’s assets and profits equal to how much stock they own. Units of stock are called “shares.”

Stocks are bought and sold predominantly on stock exchanges (though there can be private sales as well) and are the foundation of many individual investors’ portfolios. These transactions have to conform to government regulations that are meant to protect investors from fraudulent practices. Historically, they have outperformed most other investments over the long run. These investments can be purchased from most online stockbrokers.

Stock Summary

• A stock is a form of security that indicates the holder has proportionate ownership in the issuing corporation.

• Corporations issue (sell) stock to raise funds to operate their businesses. There are two main types of stock: common and preferred.

• Stocks are bought and sold predominantly on stock exchanges, though there can be private sales as well, and they are the foundation of nearly every portfolio.

• Historically, they have outperformed most other investments over the long run.

Understanding Stocks

Corporations issue (sell) stock to raise funds to operate their businesses. The holder of stock (a shareholder) buys a piece of the corporation and, depending on the type of shares held, may have a claim to part of its assets and earnings. In other words, a shareholder is now an owner of the issuing company. Ownership is determined by the number of shares a person owns relative to the number of outstanding shares. For example, if a company has 1,000 shares of stock outstanding and one person owns 100 shares, that person would own and have a claim to 10% of the company’s assetsand earnings.2

Stockholders do not own corporations; they own shares issued by corporations. But corporations are a special type of organization because the law treats them as legal persons. In other words, corporations file taxes, can borrow, can own property, can be sued, etc. The idea that a corporation is a “person” means that the corporation owns its own assets. A corporate office full of chairs and tables belongs to the corporation, and not to the shareholders.3

This distinction is important because corporate property is legally separated from the property of shareholders, which limits the liability of both the corporation and the shareholder. If the corporation goes bankrupt, a judge may order all of its assets sold—but your personal assets are not at risk. The court cannot even force you to sell your shares, although the value of your shares will have fallen drastically. Likewise, if a major shareholder goes bankrupt, they cannot sell the company’s assets to pay off their creditors.

Stockholders and Equity Ownership

What shareholders actually own are shares issued by the corporation, and the corporation owns the assets held by a firm. So if you own 33% of the shares of a company, it is incorrect to assert that you own one-third of that company; it is instead correct to state that you own 100% of one-third of the company’s shares. Shareholders cannot do as they please with a corporation or its assets. A shareholder can’t walk out with a chair because the corporation owns that chair, not the shareholder. This is known as the “separation of ownership and control.”

Owning stock gives you the right to vote in shareholder meetings, receive dividends(which are the company’s profits) if and when they are distributed, and it gives you the right to sell your shares to somebody else.

If you own a majority of shares, your voting power increases so that you can indirectly control the direction of a company by appointing its board of directors.5 This becomes most apparent when one company buys another: The acquiring company doesn’t go around buying up the building, the chairs, and the employees; it buys up all the shares. The board of directors is responsible for increasing the value of the corporation and often does so by hiring professional managers, or officers, such as the chief executive officer, or CEO.

For most ordinary shareholders, not being able to manage the company isn’t such a big deal. The importance of being a shareholder is that you are entitled to a portion of the company’s profits, which, as we will see, is the foundation of a stock’s value. The more shares you own, the larger the portion of the profits you get. Many stocks, however, do not pay out dividends and instead reinvest profits back into growing the company. These retained earnings, however, are still reflected in the value of a stock.

Common vs. Preferred Stock

There are two main types of stock: common and preferred. Common stock usually entitles the owner to vote at shareholders’ meetings and to receive any dividends paid out by the corporation. Preferred stockholders generally do not have voting rights, though they have a higher claim on assets and earnings than common stockholders. For example, owners of preferred stock receive dividends before common shareholders and have priority in the event that a company goes bankrupt and is liquidated.2

The first common stock ever issued was by the Dutch East India Company in 1602.

Companies can issue new shares whenever there is a need to raise additional cash. This process dilutes the ownership and rights of existing shareholders (provided they do not buy any of the new offerings). Corporations can also engage in stock buybacks, which benefit existing shareholders because they cause their shares to appreciate in value.

Stocks vs. Bonds

Stocks are issued by companies to raise capital, paid-up or share, in order to grow the business or undertake new projects. There are important distinctions between whether somebody buys shares directly from the company when it issues them (in the primary market) or from another shareholder (on the secondary market). When the corporation issues shares, it does so in return for money.

Bonds are fundamentally different from stocks in a number of ways. First, bondholders are creditors to the corporation and are entitled to interest as well as repayment of principal. Creditors are given legal priority over other stakeholders in the event of a bankruptcy and will be made whole first if a company is forced to sell assets in order to repay them. Shareholders, on the other hand, are last in line and often receive nothing, or mere pennies on the dollar, in the event of bankruptcy. This implies that stocks are inherently riskier investments than bonds.

Frequently Asked Questions

What Are the Types of Stock?

Broadly speaking, there are two main types of stocks, common and preferred. Common stockholders have the right to receive dividends and vote in shareholder meetings, while preferred shareholders have limited or no voting rights. Preferred stockholders typically receive higher dividend payouts, and in the event of a liquidation, a greater claim on assets than common stockholders will.

How Do You Buy a Stock?

Most often, stocks are bought and sold on stock exchanges, such as the Nasdaq or the New York Stock Exchange (NYSE). After a company goes public through an initial public offering (IPO), its stock becomes available for investors to buy and sell on an exchange. Typically, investors will use a brokerage account to purchase stock on the exchange, which will list the purchasing price (the bid) or the selling price (the offer). The price of the stock is influenced by supply and demand factors in the market, among other variables.

What Is the Difference Between a Stock and a Bond?

When a company raises capital by issuing stock, it entitles the holder to a share of ownership in the company. By contrast, when a company raises funds for the business by selling bonds, these bonds represent loans from the bondholder to the company. Bonds have terms that require the company or entity to pay back the principal along with interest rates in exchange for this loan. In addition, bondholders are granted priority over stockholders in the event of a bankruptcy, while stockholders typically fall last in line in the claim to assets.

Why Do Companies Issue Stock?

Companies issue stock to raise capital for expanding their business operations or to undertake new projects. Stock issuance in public markets also helps early investors in the company to cash out and profit from their positions in the venture.

Stock Bottom Line

A stock represents fractional ownership of equity in an organization. It is different from a bond, which is more like a loan made by creditors to the company in return for periodic payments. A company issues stock to raise capital from investors for new projects or to expand its business operations. There are two types of stock: common stock and preferred stock. Depending on the type of stock they hold, the stock owner has certain rights. A common stockholder can vote in shareholder meetings and receive dividends from the company’s profits, while the preferred stockholder receives dividends and preference over the common stockholder during company bankruptcy proceedings.

What is a Bond?

A bond is a fixed-income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments. Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations. Owners of bonds are debtholders, or creditors, of the issuer.

Bond details include the end date when the principal of the loan is due to be paid to the bond owner and usually include the terms for variable or fixed interest payments made by the borrower.

Bond Summary

• Bonds are units of corporate debt issued by companies and securitized as tradeable assets.

• A bond is referred to as a fixed-income instrument since bonds traditionally paid a fixed interest rate (coupon) to debtholders. Variable or floating interest rates are also now quite common.

• Bond prices are inversely correlated with interest rates: when rates go up, bond prices fall and vice-versa.

• Bonds have maturity dates at which point the principal amount must be paid back in full or risk default.

The Issuers of Bonds

Governments (at all levels) and corporations commonly use bonds in order to borrow money. Governments need to fund roads, schools, dams, or other infrastructure. The sudden expense of war may also demand the need to raise funds.

Similarly, corporations will often borrow to grow their business, to buy property and equipment, to undertake profitable projects, for research and development, or to hire employees. The problem that large organizations run into is that they typically need far more money than the average bank can provide.

Bonds provide a solution by allowing many individual investors to assume the role of the lender. Indeed, public debt markets let thousands of investors each lend a portion of the capital needed. Moreover, markets allow lenders to sell their bonds to other investors or to buy bonds from other individuals—long after the original issuing organization raised capital.

 

How Bonds Work

Bonds are commonly referred to as fixed-income securities and are one of the main asset classes that individual investors are usually familiar with, along with stocks (equities) and cash equivalents.

Many corporate and government bonds are publicly traded; others are traded only over-the-counter (OTC) or privately between the borrower and lender.

When companies or other entities need to raise money to finance new projects, maintain ongoing operations, or refinance existing debts, they may issue bonds directly to investors. The borrower (issuer) issues a bond that includes the terms of the loan, interest payments that will be made, and the time at which the loaned funds (bond principal) must be paid back (maturity date). The interest payment (the coupon) is part of the return that bondholders earn for loaning their funds to the issuer. The interest rate that determines the payment is called the coupon rate.

The initial price of most bonds is typically set at par, or $1,000 face value per individual bond. The actual market price of a bond depends on a number of factors: the credit quality of the issuer, the length of time until expiration, and the coupon rate compared to the general interest rate environment at the time. The face value of the bond is what will be paid back to the borrower once the bond matures.2

Most bonds can be sold by the initial bondholder to other investors after they have been issued. In other words, a bond investor does not have to hold a bond all the way through to its maturity date. It is also common for bonds to be repurchased by the borrower if interest rates decline, or if the borrower’s credit has improved, and it can reissue new bonds at a lower cost.

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Characteristics of Bonds

Most bonds share some common basic characteristics including:

• Face value is the money amount the bond will be worth at maturity; it is also the reference amount the bond issuer uses when calculating interest payments. For example, say an investor purchases a bond at a premium of $1,090, and another investor buys the same bond later when it is trading at a discount for $980. When the bond matures, both investors will receive the $1,000 face value of the bond.

• The coupon rate is the rate of interest the bond issuer will pay on the face value of the bond, expressed as a percentage.1 For example, a 5% coupon rate means that bondholders will receive 5% x $1000 face value = $50 every year.

• Coupon dates are the dates on which the bond issuer will make interest payments. Payments can be made in any interval, but the standard is semiannual payments.

• The maturity date is the date on which the bond will mature and the bond issuer will pay the bondholder the face value of the bond.

• The issue price is the price at which the bond issuer originally sells the bonds.

Two features of a bond—credit quality and time to maturity—are the principal determinants of a bond’s coupon rate. If the issuer has a poor credit rating, the risk of default is greater, and these bonds pay more interest. Bonds that have a very long maturity date also usually pay a higher interest rate. This higher compensation is because the bondholder is more exposed to interest rate and inflation risks for an extended period.

Credit ratings for a company and its bonds are generated by credit rating agencies like Standard and Poor’s, Moody’s, and Fitch Ratings. The very highest quality bonds are called “investment grade” and include debt issued by the U.S. government and very stable companies, like many utilities.

Bonds that are not considered investment grade, but are not in default, are called “high yield” or “junk” bonds. These bonds have a higher risk of default in the future and investors demand a higher coupon payment to compensate them for that risk.3

Bonds and bond portfolios will rise or fall in value as interest rates change. The sensitivity to changes in the interest rate environment is called “duration.” The use of the term duration in this context can be confusing to new bond investors because it does not refer to the length of time the bond has before maturity. Instead, duration describes how much a bond’s price will rise or fall with a change in interest rates.

The rate of change of a bond’s or bond portfolio’s sensitivity to interest rates (duration) is called “convexity.” These factors are difficult to calculate, and the analysis required is usually done by professionals.

 

Categories of Bonds

There are four primary categories of bonds sold in the markets. However, you may also see foreign bonds issued by corporations and governments on some platforms.

• Corporate bonds are issued by companies. Companies issue bonds rather than seek bank loans for debt financing in many cases because bond markets offer more favorable terms and lower interest rates.

• Municipal bonds are issued by states and municipalities. Some municipal bonds offer tax-free coupon income for investors.

• Government bonds such as those issued by the U.S. Treasury. Bonds issued by the Treasury with a year or less to maturity are called “Bills”; bonds issued with 1–10 years to maturity are called “notes”; and bonds issued with more than 10 years to maturity are called “bonds.” The entire category of bonds issued by a government treasury is often collectively referred to as “treasuries.” Government bonds issued by national governments may be referred to as sovereign debt.

• Agency bonds are those issued by government-affiliated organizations such as Fannie Mae or Freddie Mac.

Varieties of Bonds

The bonds available for investors come in many different varieties. They can be separated by the rate or type of interest or coupon payment, by being recalled by the issuer, or because they have other attributes.

Zero-Coupon Bonds

Zero-coupon bonds do not pay coupon payments and instead are issued at a discount to their par value that will generate a return once the bondholder is paid the full face value when the bond matures. U.S. Treasury bills are a zero-coupon bond.4

Convertible Bonds

Convertible bonds are debt instruments with an embedded option that allows bondholders to convert their debt into stock (equity) at some point, depending on certain conditions like the share price5. For example, imagine a company that needs to borrow $1 million to fund a new project. They could borrow by issuing bonds with a 12% coupon that matures in 10 years. However, if they knew that there were some investors willing to buy bonds with an 8% coupon that allowed them to convert the bond into stock if the stock’s price rose above a certain value, they might prefer to issue those.

The convertible bond may be the best solution for the company because they would have lower interest payments while the project was in its early stages. If the investors converted their bonds, the other shareholders would be diluted, but the company would not have to pay any more interest or the principal of the bond.

The investors who purchased a convertible bond may think this is a great solution because they can profit from the upside in the stock if the project is successful. They are taking more risk by accepting a lower coupon payment, but the potential reward if the bonds are converted could make that trade-off acceptable.

Callable Bonds

Callable bonds also have an embedded option but it is different than what is found in a convertible bond. A callable bond is one that can be “called” back by the company before it matures.6 Assume that a company has borrowed $1 million by issuing bonds with a 10% coupon that mature in 10 years. If interest rates decline (or the company’s credit rating improves) in year 5 when the company could borrow for 8%, they will call or buy the bonds back from the bondholders for the principal amount and reissue new bonds at a lower coupon rate.

A callable bond is riskier for the bond buyer because the bond is more likely to be called when it is rising in value. Remember, when interest rates are falling, bond prices rise. Because of this, callable bonds are not as valuable as bonds that aren’t callable with the same maturity, credit rating, and coupon rate.

Puttable Bond

A puttable bond allows the bondholders to put or sell the bond back to the company before it has matured. This is valuable for investors who are worried that a bond may fall in value, or if they think interest rates will rise and they want to get their principal back before the bond falls in value.

The bond issuer may include a put option in the bond that benefits the bondholders in return for a lower coupon rate or just to induce the bond sellers to make the initial loan. A puttable bond usually trades at a higher value than a bond without a put option but with the same credit rating, maturity, and coupon rate because it is more valuable to the bondholders.

The possible combinations of embedded puts, calls, and convertibility rights in a bond are endless and each one is unique. There isn’t a strict standard for each of these rights and some bonds will contain more than one kind of “option” which can make comparisons difficult. Generally, individual investors rely on bond professionals to select individual bonds or bond funds that meet their investing goals.

Pricing Bonds

The market prices bonds based on their particular characteristics. A bond’s price changes on a daily basis, just like that of any other publicly traded security, where supply and demand in any given moment determine that observed price.

But there is a logic to how bonds are valued. Up to this point, we’ve talked about bonds as if every investor holds them to maturity. It’s true that if you do this you’re guaranteed to get your principal back plus interest; however, a bond does not have to be held to maturity. At any time, a bondholder can sell their bonds in the open market, where the price can fluctuate, sometimes dramatically.

The price of a bond changes in response to changes in interest rates in the economy. This is due to the fact that for a fixed-rate bond, the issuer has promised to pay a coupon based on the face value of the bond—so for a $1,000 par, 10% annual coupon bond, the issuer will pay the bondholder $100 each year.

Say that prevailing interest rates are also 10% at the time that this bond is issued, as determined by the rate on a short-term government bond. An investor would be indifferent to investing in the corporate bond or the government bond since both would return $100. However, imagine a little while later, that the economy has taken a turn for the worse and interest rates dropped to 5%. Now, the investor can only receive $50 from the government bond, but would still receive $100 from the corporate bond.

This difference makes the corporate bond much more attractive. So investors in the market will bid up to the price of the bond until it trades at a premium that equalizes the prevailing interest rate environment—in this case, the bond will trade at a price of $2,000 so that the $100 coupon represents 5%. Likewise, if interest rates soared to 15%, then an investor could make $150 from the government bond and would not pay $1,000 to earn just $100. This bond would be sold until it reached a price that equalized the yields, in this case to a price of $666.67.

Inverse to Interest Rates

This is why the famous statement that a bond’s price varies inversely with interest rates works. When interest rates go up, bond prices fall in order to have the effect of equalizing the interest rate on the bond with prevailing rates, and vice versa.

Another way of illustrating this concept is to consider what the yield on our bond would be given a price change, instead of given an interest rate change. For example, if the price were to go down from $1,000 to $800, then the yield goes up to 12.5%. This happens because you are getting the same guaranteed $100 on an asset that is worth $800 ($100/$800). Conversely, if the bond goes up in price to $1,200, the yield shrinks to 8.33% ($100/$1,200).

Yield-to-Maturity (YTM)

The yield-to-maturity (YTM) of a bond is another way of considering a bond’s price. YTM is the total return anticipated on a bond if the bond is held until the end of its lifetime. Yield to maturity is considered a long-term bond yield but is expressed as an annual rate. In other words, it is the internal rate of return of an investment in a bond if the investor holds the bond until maturity and if all payments are made as scheduled.7

YTM is a complex calculation but is quite useful as a concept evaluating the attractiveness of one bond relative to other bonds of different coupons and maturity in the market. The formula for YTM involves solving for the interest rate in the following equation, which is no easy task, and therefore most bond investors interested in YTM will use a computer:

YTM=nPresent ValueFace Value

We can also measure the anticipated changes in bond prices given a change in interest rates with a measure known as the duration of a bond. Duration is expressed in units of the number of years since it originally referred to zero-coupon bonds, whose duration isits maturity.

For practical purposes, however, duration represents the price change in a bond given a 1% change in interest rates. We call this second, more practical definition the modified duration of a bond.

The duration can be calculated to determine the price sensitivity to interest rate changes of a single bond, or for a portfolio of many bonds. In general, bonds with long maturities, and also bonds with low coupons have the greatest sensitivity to interest rate changes. A bond’s duration is not a linear risk measure, meaning that as prices and rates change, the duration itself changes, and convexity measures this relationship.

Bond Example

A bond represents a promise by a borrower to pay a lender their principal and usually interest on a loan. Bonds are issued by governments, municipalities, and corporations. The interest rate (coupon rate), principal amount, and maturities will vary from one bond to the next in order to meet the goals of the bond issuer (borrower) and the bond buyer (lender). Most bonds issued by companies include options that can increase or decrease their value and can make comparisons difficult for non-professionals. Bonds can be bought or sold before they mature, and many are publicly listed and can be traded with a broker.

While governments issue many bonds, corporate bonds can be purchased from brokerages. If you’re interested in this investment, you’ll need to pick a broker. You can take a look at Investopedia’s list of the best online stock brokers to get an idea of which brokers best fit your needs.

Because fixed-rate coupon bonds will pay the same percentage of their face value over time, the market price of the bond will fluctuate as that coupon becomes more or less attractive compared to the prevailing interest rates.

Imagine a bond that was issued with a coupon rate of 5% and a $1,000 par value. The bondholder will be paid $50 in interest income annually (most bond coupons are split in half and paid semiannually). As long as nothing else changes in the interest rate environment, the price of the bond should remain at its par value.

However, if interest rates begin to decline and similar bonds are now issued with a 4% coupon, the original bond has become more valuable. Investors who want a higher coupon rate will have to pay extra for the bond in order to entice the original owner to sell. The increased price will bring the bond’s total yield down to 4% for new investors because they will have to pay an amount above par value to purchase the bond.

On the other hand, if interest rates rise and the coupon rate for bonds like this one rises to 6%, the 5% coupon is no longer attractive. The bond’s price will decrease and begin selling at a discount compared to the par value until its effective return is 6%.

How Do Bonds Work?

Bonds are a type of security sold by governments and corporations, as a way of raising money from investors. From the seller’s perspective, selling bonds is therefore a way of borrowing money. From the buyer’s perspective, buying bonds is a form of investment because it entitles the purchaser to guaranteed repayment of principal as well as a stream of interest payments. Some types of bonds also offer other benefits, such as the ability to convert the bond into shares in the issuing company’s stock.

The bond market tends to move inversely with interest rates because bonds will trade at a discount when interest rates are rising and at a premium when interest rates are falling.

What Is an Example of a Bond?

To illustrate, consider the case of XYZ Corporation. XYZ wishes to borrow $1 million to finance the construction of a new factory but is unable to obtain this financing from a bank. Instead, XYZ decides to raise the money by selling $1 million worth of bonds to investors. Under the terms of the bond, XYZ promises to pay its bondholders 5% interest per year for 5 years, with interest paid semiannually. Each of the bonds has a face value of $1,000, meaning XYZ is selling a total of 1,000 bonds.

What Are Some Different Types of Bonds?

The example above is for a typical bond, but there are many special types of bonds available.8 For example, zero-coupon bonds do not pay interest payments during the term of the bond. Instead, their par value—the amount they pay back to the investor at the end of the term—is greater than the amount paid by the investor when they purchased the bond.

Convertible bonds, on the other hand, give the bondholder the right to exchange their bond for shares of the issuing company, if certain targets are reached.5 Many other types of bonds exist, offering features related to tax planning, inflation hedging, and others.

What is a Mutual Fund

A mutual fund is a type of financial vehicle made up of a pool of money collected from many investors to invest in securities like stocks, bonds, money market instruments, and other assets. Mutual funds are operated by professional money managers, who allocate the fund’s assets and attempt to produce capital gains or income for the fund’s investors. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus.

Mutual Fund Summary

• A mutual fund is a type of investment vehicle consisting of a portfolio of stocks, bonds, or other securities.

• Mutual funds give small or individual investors access to diversified, professionally managed portfolios at a low price.

• Mutual funds are divided into several kinds of categories, representing the kinds of securities they invest in, their investment objectives, and the type of returns they seek.

• Mutual funds charge annual fees (called expense ratios) and, in some cases, commissions, which can affect their overall returns.

• The overwhelming majority of money in employer-sponsored retirement plans goes into mutual funds.

• The primary benefit of a Mutual Fund is diversification.

Diversification

Diversification, or the mixing of investments and assets within a portfolio to reduce risk, is one of the advantages of investing in mutual funds. Experts advocate diversification as a way of enhancing a portfolio’s returns, while reducing its risk. Buying individual company stocks and offsetting them with industrial sector stocks, for example, offers some diversification.

Buying a mutual fund can achieve diversification cheaper and faster than by buying individual securities. Large mutual funds typically own hundreds of different stocks in many different industries. It wouldn’t be practical for an investor to build this kind of a portfolio with a small amount of money.

However, a truly diversified portfolio has also been designed with proper asset allocation by including securities with different capitalizations and industries and bonds with varying maturities and issuers.

Mutual funds give small or individual investors access to professionally managed portfolios of equities, bonds, and other securities. Each shareholder, therefore, participates proportionally in the gains or losses of the fund. Mutual funds invest in a vast number of securities, and performance is usually tracked as the change in the total market cap of the fund—derived by the aggregating performance of the underlying investments. The primary benefit of a Mutual Fund is diversification.

Understanding Mutual Funds

Mutual funds pool money from the investing public and use that money to buy other securities, usually stocks and bonds. The value of the mutual fund company depends on the performance of the securities it decides to buy. So, when you buy a unit or share of a mutual fund, you are buying the performance of its portfolio or, more precisely, a part of the portfolio’s value. Investing in a share of a mutual fund is different from investing in shares of stock. Unlike stock, mutual fund shares do not give its holders any voting rights. A share of a mutual fund represents investments in many different stocks (or other securities) instead of just one holding.

That’s why the price of a mutual fund share is referred to as the net asset value (NAV)per share, sometimes expressed as NAVPS. A fund’s NAV is derived by dividing the total value of the securities in the portfolio by the total amount of shares outstanding. Outstanding shares are those held by all shareholders, institutional investors, and company officers or insiders. Mutual fund shares can typically be purchased or redeemed as needed at the fund’s current NAV, which—unlike a stock price—doesn’t fluctuate during market hours, but it is settled at the end of each trading day. Ergo, the price of a mutual fund is also updated when the NAVPS is settled.

The average mutual fund holds over a hundred different securities, which means mutual fund shareholders gain important diversification at a low price. Consider an investor who buys only Google stock before the company has a bad quarter. They stand to lose a great deal of value because all of their dollars are tied to one company. On the other hand, a different investor may buy shares of a mutual fund that happens to own some Google stock. When Google has a bad quarter, they lose significantly less because Google is just a small part of the fund’s portfolio.

How Mutual Funds Work

A mutual fund is both an investment and an actual company. This dual nature may seem strange, but it is no different from how a share of AAPL is a representation of Apple Inc. When an investor buys Apple stock, he is buying partial ownership of the company and its assets. Similarly, a mutual fund investor is buying partial ownership of the mutual fund company and its assets. The difference is that Apple is in the business of making innovative devices and tablets, while a mutual fund company is in the business of making investments.

3 Ways Mutual Funds Pay Investors:

1. Income is earned from dividends on stocks and interest on bonds held in the fund’s portfolio. A fund pays out nearly all of the income it receives over the year to fund owners in the form of a distribution. Funds often give investors a choice either to receive a check for distributions or to reinvest the earnings and get more shares.

2. If the fund sells securities that have increased in price, the fund has a capital gain. Most funds also pass on these gains to investors in a distribution.

3. If fund holdings increase in price but are not sold by the fund manager, the fund’s shares increase in price. You can then sell your mutual fund shares for a profit in the market.

Fund Managers

If a mutual fund is construed as a virtual company, its CEO is the fund manager, sometimes called its investment adviser. The fund manager is hired by a board of directors and is legally obligated to work in the best interest of mutual fund shareholders. Most fund managers are also owners of the fund. There are very few other employees in a mutual fund company. The investment adviser or fund manager may employ some analysts to help pick investments or perform market research. A fund accountant is kept on staff to calculate the fund’s NAV, the daily value of the portfolio that determines if share prices go up or down. Mutual funds need to have a compliance officer or two, and probably an attorney, to keep up with government regulations.

Most mutual funds are part of a much larger investment company; the biggest have hundreds of separate mutual funds. Some of these fund companies are names familiar to the general public, such as Fidelity Investments, The Vanguard Group, T. Rowe Price, and Oppenheimer.

Types of Mutual Funds

Mutual funds are divided into several kinds of categories, representing the kinds of securities they have targeted for their portfolios and the type of returns they seek. There is a fund for nearly every type of investor or investment approach. Other common types of mutual funds include money market funds, sector funds, alternative funds, smart-beta funds, target-date funds, and even funds of funds, or mutual funds that buy shares of other mutual funds.

Equity Funds

The largest category is that of equity or stock funds. As the name implies, this sort of fund invests principally in stocks. Within this group are various subcategories. Some equity funds are named for the size of the companies they invest in: small-, mid-, or large-cap. Others are named by their investment approach: aggressive growth, income-oriented, value, and others. Equity funds are also categorized by whether they invest in domestic (U.S.) stocks or foreign equities. There are so many different types of equity funds because there are many different types of equities. A great way to understand the universe of equity funds is to use a style box, an example of which is below.

The idea here is to classify funds based on both the size of the companies invested in (their market caps) and the growth prospects of the invested stocks. The term value fund refers to a style of investing that looks for high-quality, low-growth companies that are out of favor with the market. These companies are characterized by low price-to-earnings (P/E) ratios, low price-to-book (P/B) ratios, and high dividend yields. Conversely, spectrums are growth funds, which look to companies that have had (and are expected to have) strong growth in earnings, sales, and cash flows. These companies typically have high P/E ratios and do not pay dividends. A compromise between strict value and growth investment is a “blend,” which simply refers to companies that are neither value nor growth stocks and are classified as being somewhere in the middle.

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The other dimension of the style box has to do with the size of the companies that a mutual fund invests in. Large-cap companies have high market capitalizations, with values over $10 billion. Market cap is derived by multiplying the share price by the number of shares outstanding. Large-cap stocks are typically blue chip firms that are often recognizable by name. Small-cap stocks refer to those stocks with a market cap ranging from $250 million to $2 billion. These smaller companies tend to be newer, riskier investments. Mid-cap stocks fill in the gap between small- and large-cap.

A mutual fund may blend its strategy between investment style and company size. For example, a large-cap value fund would look to large-cap companies that are in strong financial shape but have recently seen their share prices fall and would be placed in the upper left quadrant of the style box (large and value). The opposite of this would be a fund that invests in startup technology companies with excellent growth prospects: small-cap growth. Such a mutual fund would reside in the bottom right quadrant (small and growth).

Fixed-Income Funds

Another big group is the fixed income category. A fixed-income mutual fund focuses on investments that pay a set rate of return, such as government bonds, corporate bonds, or other debt instruments. The idea is that the fund portfolio generates interest income, which it then passes on to the shareholders.

Sometimes referred to as bond funds, these funds are often actively managed and seek to buy relatively undervalued bonds in order to sell them at a profit. These mutual funds are likely to pay higher returns than certificates of deposit and money market investments, but bond funds aren’t without risk. Because there are many different types of bonds, bond funds can vary dramatically depending on where they invest. For example, a fund specializing in high-yield junk bonds is much riskier than a fund that invests in government securities. Furthermore, nearly all bond funds are subject to interest rate risk, which means that if rates go up, the value of the fund goes down.

Index Funds

Another group, which has become extremely popular in the last few years, falls under the moniker “index funds.” Their investment strategy is based on the belief that it is very hard, and often expensive, to try to beat the market consistently. So, the index fund manager buys stocks that correspond with a major market index such as the S&P 500 or the Dow Jones Industrial Average (DJIA). This strategy requires less research from analysts and advisors, so there are fewer expenses to eat up returns before they are passed on to shareholders. These funds are often designed with cost-sensitive investors in mind.

Balanced Funds

Balanced funds invest in a hybrid of asset classes, whether stocks, bonds, money market instruments, or alternative investments. The objective is to reduce the risk of exposure across asset classes.This kind of fund is also known as an asset allocation fund. There are two variations of such funds designed to cater to the investors objectives.

Some funds are defined with a specific allocation strategy that is fixed, so the investor can have a predictable exposure to various asset classes. Other funds follow a strategy for dynamic allocation percentages to meet various investor objectives. This may include responding to market conditions, business cycle changes, or the changing phases of the investor’s own life.

While the objectives are similar to those of a balanced fund, dynamic allocation funds do not have to hold a specified percentage of any asset class. The portfolio manager is therefore given freedom to switch the ratio of asset classes as needed to maintain the integrity of the fund’s stated strategy.

Money Market Funds

The money market consists of safe (risk-free), short-term debt instruments, mostly government Treasury bills. This is a safe place to park your money. You won’t get substantial returns, but you won’t have to worry about losing your principal. A typical return is a little more than the amount you would earn in a regular checking or savings account and a little less than the average certificate of deposit (CD). While money market funds invest in ultra-safe assets, during the 2008 financial crisis, some money market funds did experience losses after the share price of these funds, typically pegged at $1, fell below that level and broke the buck.

Income Funds

Income funds are named for their purpose: to provide current income on a steady basis. These funds invest primarily in government and high-quality corporate debt, holding these bonds until maturity in order to provide interest streams. While fund holdings may appreciate in value, the primary objective of these funds is to provide steady cash flow to investors. As such, the audience for these funds consists of conservative investors and retirees. Because they produce regular income, tax-conscious investors may want to avoid these funds.

International/Global Funds

An international fund (or foreign fund) invests only in assets located outside your home country. Global funds, meanwhile, can invest anywhere around the world, including within your home country. It’s tough to classify these funds as either riskier or safer than domestic investments, but they have tended to be more volatile and have unique country and political risks. On the flip side, they can, as part of a well-balanced portfolio, actually reduce risk by increasing diversification, since the returns in foreign countries may be uncorrelated with returns at home. Although the world’s economies are becoming more interrelated, it is still likely that another economy somewhere is outperforming the economy of your home country.

Specialty Funds

This classification of mutual funds is more of an all-encompassing category that consists of funds that have proved to be popular but don’t necessarily belong to the more rigid categories we’ve described so far. These types of mutual funds forgo broad diversification to concentrate on a certain segment of the economy or a targeted strategy. Sector funds are targeted strategy funds aimed at specific sectors of the economy, such as financial, technology, health, and so on. Sector funds can, therefore, be extremely volatile since the stocks in a given sector tend to be highly correlated with each other. There is a greater possibility for large gains, but a sector may also collapse (for example, the financial sector in 2008 and 2009).

Regional funds make it easier to focus on a specific geographic area of the world. This can mean focusing on a broader region (say Latin America) or an individual country (for example, only Brazil). An advantage of these funds is that they make it easier to buy stock in foreign countries, which can otherwise be difficult and expensive. Just like for sector funds, you have to accept the high risk of loss, which occurs if the region goes into a bad recession.

Socially responsible funds (or ethical funds) invest only in companies that meet the criteria of certain guidelines or beliefs. For example, some socially responsible funds do not invest in “sin” industries such as tobacco, alcoholic beverages, weapons, or nuclear power. The idea is to get competitive performance while still maintaining a healthy conscience. Other such funds invest primarily in green technology, such as solar and wind power or recycling.

What is an ETF

Exchange Traded Funds (ETFs) A twist on the mutual fund is the exchange traded fund (ETF). These ever more popular investment vehicles pool investments and employ strategies consistent with mutual funds, but they are structured as investment trusts that are traded on stock exchanges and have the added benefits of the features of stocks.

• ETFs can be bought and sold at any point throughout the trading day.

• ETFs can also be sold short or purchased on margin.

• ETFs also typically carry lower fees than the equivalent mutual fund.

• Many ETFs also benefit from active options markets, where investors can hedgeor leverage their positions.

• ETFs also enjoy tax advantages from mutual funds.

• Compared to mutual funds, ETFs tend to be more cost effective and more liquid.

• The popularity of ETFs speaks to their versatility and convenience.

Mutual Fund Fees

A mutual fund will classify expenses into either annual operating fees or shareholder fees. Annual fund operating fees are an annual percentage of the funds under management, usually ranging from 1–3%. Annual operating fees are collectively known as the expense ratio. A fund’s expense ratio is the summation of the advisory or management fee and its administrative costs.

Shareholder fees, which come in the form of sales charges, commissions, and redemption fees, are paid directly by investors when purchasing or selling the funds. Sales charges or commissions are known as “the load” of a mutual fund. When a mutual fund has a front-end load, fees are assessed when shares are purchased. For a back-end load, mutual fund fees are assessed when an investor sells his shares.

Sometimes, however, an investment company offers a no-load mutual fund, which doesn’t carry any commission or sales charge. These funds are distributed directly by an investment company, rather than through a secondary party.

Some funds also charge fees and penalties for early withdrawals or selling the holding before a specific time has elapsed. Also, the rise of exchange-traded funds, which have much lower fees thanks to their passive management structure, have been giving mutual funds considerable competition for investors’ dollars. Articles from financial media outlets regarding how fund expense ratios and loads can eat into rates of return have also stirred negative feelings about mutual funds.

Classes of Mutual Fund Shares

Mutual fund shares come in several classes. Their differences reflect the number and size of fees associated with them.

Currently, most individual investors purchase mutual funds with A shares through a broker. This purchase includes a front-end load of up to 5% or more, plus management fees and ongoing fees for distributions, also known as 12b-1 fees. To top it off, loads on A shares vary quite a bit, which can create a conflict of interest. Financial advisors selling these products may encourage clients to buy higher-load offerings to bring in bigger commissions for themselves. With front-end funds, the investor pays these expenses as they buy into the fund.

To remedy these problems and meet fiduciary-rule standards, investment companies have started designating new share classes, including “level load” C shares, which generally don’t have a front-end load but carry a 12b-1 annual distribution fees of up to 1%.

Funds that charge management and other fees when an investor sell their holdings are classified as Class B shares.

A New Class of Fund Shares

A relatively new share class developed in 2016 consists of clean shares. Clean shares do not have front-end sales loads or annual 12b-1 fees for fund services. American Funds, and MFS are some fund companies currently offering clean shares. By standardizing fees and loads, the new classes enhance transparency for mutual fund investors and most likely save them money.

Advantages of Mutual Funds

There are a variety of reasons that mutual funds have been the retail investor’s vehicle of choice for decades. The overwhelming majority of money in employer-sponsored retirement plans goes into mutual funds. Multiple mergers have equated to mutual funds over time.

More About Diversification

Diversification, or the mixing of investments and assets within a portfolio to reduce risk, is one of the advantages of investing in mutual funds. Experts advocate diversification as a way of enhancing a portfolio’s returns, while reducing its risk. Buying individual company stocks and offsetting them with industrial sector stocks, for example, offers some diversification. However, a truly diversified portfolio has securities with different capitalizations and industries and bonds with varying maturities and issuers. Buying a mutual fund can achieve diversification cheaper and faster than by buying individual securities. Large mutual funds typically own hundreds of different stocks in many different industries. It wouldn’t be practical for an investor to build this kind of a portfolio with a small amount of money.

Easy Access

Trading on the major stock exchanges, mutual funds can be bought and sold with relative ease, making them highly liquid investments. Also, when it comes to certain types of assets, like foreign equities or exotic commodities, mutual funds are often the most feasible way—in fact, sometimes the only way—for individual investors to participate.

Economies of Scale

Mutual funds also provide economies of scale. Buying one spares the investor of the numerous commission charges needed to create a diversified portfolio. Buying only one security at a time leads to large transaction fees, which will eat up a good chunk of the investment. Also, the $100 to $200 an individual investor might be able to afford is usually not enough to buy a round lot of the stock, but it will purchase many mutual fund shares. The smaller denominations of mutual funds allow investors to take advantage of dollar cost averaging.

Because a mutual fund buys and sells large amounts of securities at a time, its transaction costs are lower than what an individual would pay for securities transactions. Moreover, a mutual fund, since it pools money from many smaller investors, can invest in certain assets or take larger positions than a smaller investor could. For example, the fund may have access to IPO placements or certain structured products only available to institutional investors.

Professional Management

A primary advantage of mutual funds is not having to pick stocks and manage investments. Instead, a professional investment manager takes care of all of this using careful research and skillful trading. Investors purchase funds because they often do not have the time or the expertise to manage their own portfolios, or they don’t have access to the same kind of information that a professional fund has. A mutual fund is a relatively inexpensive way for a small investor to get a full-time manager to make and monitor investments. Most private, non-institutional money managers deal only with high-net-worth individuals—people with at least six figures to invest. However, mutual funds, as noted above, require much lower investment minimums. So, these funds provide a low-cost way for individual investors to experience and hopefully benefit from professional money management.

Variety and Freedom of Choice

Investors have the freedom to research and select from managers with a variety of styles and management goals. For instance, a fund manager may focus on value investing, growth investing, developed markets, emerging markets, income, or macroeconomic investing, among many other styles. One manager may also oversee funds that employ several different styles. This variety allows investors to gain exposure to not only stocks and bonds but also commodities, foreign assets, and real estate through specialized mutual funds. Some mutual funds are even structured to profit from a falling market (known as bear funds). Mutual funds provide opportunities for foreign and domestic investment that may not otherwise be directly accessible to ordinary investors.

Transparency

Mutual funds are subject to industry regulation that ensures accountability and fairness to investors.

Pros

• Liquidity

• Diversification

• Minimal investment requirements

• Professional management

• Variety of offerings

Cons

• High fees, commissions, and other expenses

• Large cash presence in portfolios

• No FDIC coverage

• Difficulty in comparing funds

• Lack of transparency in holdings

Mutual Funds: How Many is Too Many?

Disadvantages of Mutual Funds

Liquidity, diversification, and professional management all make mutual funds attractive options for younger, novice, and other individual investors who don’t want to actively manage their money. However, no asset is perfect, and mutual funds have drawbacks too.

Fluctuating Returns

Like many other investments without a guaranteed return, there is always the possibility that the value of your mutual fund will depreciate. Equity mutual funds experience price fluctuations, along with the stocks that make up the fund. The Federal Deposit Insurance Corporation (FDIC) does not back up mutual fund investments, and there is no guarantee of performance with any fund. Of course, almost every investment carries risk. It is especially important for investors in money market funds to know that, unlike their bank counterparts, these will not be insured by the FDIC.10

Cash Drag

Mutual funds pool money from thousands of investors, so every day people are putting money into the fund as well as withdrawing it. To maintain the capacity to accommodate withdrawals, funds typically have to keep a large portion of their portfolios in cash. Having ample cash is excellent for liquidity, but money that is sitting around as cash and not working for you is not very advantageous. Mutual funds require a significant amount of their portfolios to be held in cash in order to satisfy share redemptions each day. To maintain liquidity and the capacity to accommodate withdrawals, funds typically have to keep a larger portion of their portfolio as cash than a typical investor might. Because cash earns no return, it is often referred to as a “cash drag.”

High Costs

Mutual funds provide investors with professional management, but it comes at a cost—those expense ratios mentioned earlier. These fees reduce the fund’s overall payout, and they’re assessed to mutual fund investors regardless of the performance of the fund. As you can imagine, in years when the fund doesn’t make money, these fees only magnify losses. Creating, distributing, and running a mutual fund is an expensive undertaking. Everything from the portfolio manager’s salary to the investors’ quarterly statements cost money. Those expenses are passed on to the investors. Since fees vary widely from fund to fund, failing to pay attention to the fees can have negative long-term consequences. Actively managed funds incur transaction costs that accumulate over each year. Remember, every dollar spent on fees is a dollar that is not invested to grow over time.

“Diworsification” and Dilution

“Diworsification“—a play on words—is an investment or portfolio strategy that implies too much complexity can lead to worse results. Many mutual fund investors tend to overcomplicate matters. That is, they acquire too many funds that are highly related and, as a result, don’t get the risk-reducing benefits of diversification. These investors may have made their portfolio more exposed. At the other extreme, just because you own mutual funds doesn’t mean you are automatically diversified. For example, a fund that invests only in a particular industry sector or region is still relatively risky.

In other words, it’s possible to have poor returns due to too much diversification. Because mutual funds can have small holdings in many different companies, high returns from a few investments often don’t make much difference on the overall return. Dilution is also the result of a successful fund growing too big. When new money pours into funds that have had strong track records, the manager often has trouble finding suitable investments for all the new capital to be put to good use.

One thing that can lead to diworsification is the fact that a fund’s purpose or makeup isn’t always clear. Fund advertisements can guide investors down the wrong path. The Securities and Exchange Commission (SEC) requires that funds have at least 80% of assets in the particular type of investment implied in their names. How the remaining assets are invested is up to the fund manager.11 However, the different categories that qualify for the required 80% of the assets may be vague and wide-ranging. A fund can, therefore, manipulate prospective investors via its title. A fund that focuses narrowly on Congolese stocks, for example, could be sold with a far-ranging title like “International High-Tech Fund.”

Active Fund Management

Many investors debate whether or not the professionals are any better than you or I at picking stocks. Management is by no means infallible, and even if the fund loses money, the manager still gets paid. Actively managed funds incur higher fees, but increasingly passive index funds have gained popularity. These funds track an index such as the S&P 500 and are much less costly to hold. Actively managed funds over several time periods have failed to outperform their benchmark indices, especially after accounting for taxes and fees.12

Lack of Liquidity

A mutual fund allows you to request that your shares be converted into cash at any time, however, unlike stock that trades throughout the day, many mutual fund redemptions take place only at the end of each trading day.

Taxes

When a fund manager sells a security, a capital-gains tax is triggered. Investors who are concerned about the impact of taxes need to keep those concerns in mind when investing in mutual funds. Taxes can be mitigated by investing in tax-sensitive funds or by holding non-tax sensitive mutual funds in a tax-deferred account, such as a 401(k)or IRA.13

Evaluating Funds

Researching and comparing funds can be difficult. Unlike stocks, mutual funds do not offer investors the opportunity to juxtapose the price to earnings (P/E) ratio, sales growth, earnings per share (EPS), or other important data. A mutual fund’s net asset value can offer some basis for comparison, but given the diversity of portfolios, comparing the proverbial apples to apples can be difficult, even among funds with similar names or stated objectives. Only index funds tracking the same markets tend to be genuinely comparable.

Example of a Mutual Fund

One of the most famous mutual funds in the investment universe is Fidelity Investments’ Magellan Fund (FMAGX). Established in 1963, the fund had an investment objective of capital appreciation via investment in common stocks.14 The fund’s glory days were between 1977 and 1990, when Peter Lynch served as its portfolio manager. Under Lynch’s tenure, Magellan’s assets under management increased from $18 million to $14 billion.15

Even after Lynch left, Fidelity’s performance continued strong, and assets under management (AUM) grew to nearly $110 billion in 2000. By 1997, the fund had become so large that Fidelity closed it to new investors and would not reopen it until 2008.16

As of March 2022, Fidelity Magellan has nearly $28 billion in assets and has been managed by Sammy Simnegar since Feb. 2019.14 The fund’s performance has pretty much tracked or slightly surpassed that of the S&P 500.

What is an Index Fund

An index fund is a type of mutual fund or exchange-traded fund (ETF) with a portfolioconstructed to match or track the components of a financial market index, such as the Standard & Poor’s 500 Index (S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses, and low portfolio turnover. These funds follow their benchmark index regardless of the state of the markets.

Index funds are generally considered ideal core portfolio holdings for retirement accounts, such as individual retirement accounts (IRAs) and 401(k) accounts. Legendary investor Warren Buffett has recommended index funds as a haven for savings for the later years of life. Rather than picking out individual stocks for investment, he has said, it makes more sense for the average investor to buy all of the S&P 500 companies at the low cost that an index fund offers.

Index Fund Summary

• An index fund is a portfolio of stocks or bonds designed to mimic the composition and performance of a financial market index.

• Index funds have lower expenses and fees than actively managed funds.

• Index funds follow a passive investment strategy.

• Index funds seek to match the risk and return of the market based on the theory that in the long term, the market will outperform any single investment.

John Bogle on Starting World’s First Index Fund

How an Index Fund Works

“Indexing” is a form of passive fund management. Instead of a fund portfolio manager actively stock picking and market timing—that is, choosing securities to invest in and strategizing when to buy and sell them—the fund manager builds a portfolio whose holdings mirror the securities of a particular index. The idea is that by mimicking the profile of the index—the stock market as a whole, or a broad segment of it—the fund will match its performance as well.

There is an index and an index fund for nearly every financial market in existence. In the United States, the most popular index funds track the S&P 500. But several other indexes are widely used as well, including:

• Wilshire 5000 Total Market Index, the largest U.S. equities index1

• MSCI EAFE Index, consisting of foreign stocks from Europe, Australasia, and the Far East2

• Bloomberg U.S. Aggregate Bond Index, which follows the total bond market3

• Nasdaq Composite Index, made up of 3,000 stocks listed on the Nasdaqexchange4

• Dow Jones Industrial Average (DJIA), consisting of 30 large-cap companies5

An index fund tracking the DJIA, for example, would invest in the same 30 large and publicly owned companies that comprise that index.

Portfolios of index funds only change substantially when their benchmark indexes change. If the fund is following a weighted index, its managers may periodically rebalance the percentage of different securities to reflect the weight of their presence in the benchmark. Weighting is a method that balances out the influence of any single holding in an index or a portfolio.

Many index ETFs replicate market indexes in much the same way that index mutual funds do, and they may be more liquid and/or cost-effective for some investors.

Index Funds vs. Actively Managed Funds

Investing in an index fund is a form of passive investing. The opposite strategy is active investing, as realized in actively managed mutual funds—the ones with the securities-picking, market-timing portfolio that managers described above.

Lower Costs

One primary advantage that index funds have over their actively managed counterparts is the lower management expense ratio. A fund’s expense ratio—also known as the management expense ratio—includes all of the operating expenses such as the payment to advisors and managers, transaction fees, taxes, and accounting fees.6

Because the index fund managers are simply replicating the performance of a benchmark index, they do not need the services of research analysts and others who assist in the stock-selection process. Index fund managers trade holdings less often, incurring fewer transaction fees and commissions. In contrast, actively managed funds have larger staffs and conduct more transactions, driving up the cost of doing business.

The extra costs of fund management are reflected in the fund’s expense ratio and get passed on to investors. As a result, cheap index funds often cost less than 1 percent—0.2% to 0.5% is typical, with some firms offering even lower expense ratios of 0.05% or less—compared to the much higher fees that actively managed funds command, typically 1% to 2.5%.

Expense ratios directly impact the overall performance of a fund. Actively managed funds, with their often-higher expense ratios, are automatically at a disadvantage to index funds and struggle to keep up with their benchmarks in terms of overall return.

If you have an online brokerage account, check its mutual fund or ETF screener to see which index funds are available to you.

Pros

• Lower risk through diversification

• Low expense ratios

• Strong long-term returns

• Ideal for passive, buy-and-hold investors

• Lower taxes for investors

Cons

• Vulnerable to market swings and crashes

• Lack of flexibility

• No human element

• Limited gains

Better Returns?

Advocates argue that passive funds have been successful in outperforming most actively managed mutual funds. Indeed, a majority of mutual funds fail to beat their benchmark or broad market indexes. For instance, during the five-year period ending Dec. 31, 2020, approximately 75% of large-cap U.S. funds generated a return that was less than that of the S&P 500, according to SPIVA Scorecard data from S&P Dow Jones Indices.7

On the other hand, passively managed funds do not attempt to beat the market. Their strategy instead seeks to match the overall risk and return of the market, on the theory that the market always wins.

Passive management leading to positive performance tends to be true over the long term. With shorter time spans, active mutual funds do better. The SPIVA Scorecard indicates that in a span of one year, only about 60% of large-cap mutual funds underperformed the S&P 500. In other words, approximately two-fifths of them beat it in the short term. Also, in other categories, actively managed money rules. As an example, more than 86% of midcap mutual funds beat their S&P MidCap 400 Growth Index benchmark in the course of a year.

Real-World Example of Index Funds

Index funds have been around since the 1970s. The popularity of passive investing, the appeal of low fees, and a long-running bull market have combined to send them soaring in the 2010s. For 2021, according to Morningstar Research, investors poured more than $400 billion into index funds across all asset classes. For the same period, actively managed funds experienced $188 billion in outflows.8

The one fund that started it all, founded by Vanguard chair John Bogle in 1976, remains one of the best for its overall long-term performance and low cost. The Vanguard 500 Index Fund has tracked the S&P 500 faithfully, in composition and performance. As of June 2021, Vanguard’s Admiral Shares posted an average annual return of 7.84% vs. the S&P 500’s 7.86%. The expense ratio is 0.04%, and its minimum investment is $3,000.

How do index exchange-traded funds (index ETFs) work?

Index funds may be structured as exchange-traded funds (ETFs). These products are essentially portfolios of stocks that are managed by a professional financial firm, in which each share represents a small ownership stake in the entire portfolio. For index funds, the goal of the financial firm is not to outperform the underlying index but simply to match its performance. If, for example, a particular stock makes up 1% of the index, then the firm managing the index fund will seek to mimic that same composition by making 1% of its portfolio consist of that stock.

Do index funds have fees?

Yes, index funds have fees, but they are generally much lower than those of competing products. Many index funds offer fees of less than 0.20%, whereas active funds often charge fees of more than 1.00%. This difference in fees can have a large effect on investors’ returns when compounded over longer time frames. This is one of the main reasons why index funds have become such a popular investment option in recent years.

Exchange-Traded Fund (ETF)

An exchange-traded fund (ETF) is a type of pooled investment security that operates much like a mutual fund – except that an ETF is in many ways far superior to a Mutual Fund. While mutual funds and ETFs are similar in many respects, they also have some key differences. A major difference between the two is that ETFs can be traded intra-day like stocks, while mutual funds only can be purchased at the end of each trading day based on a calculated price known as the net asset value.

Typically, ETFs will track a particular index, sector, commodity, or other asset, but unlike mutual funds, ETFs can be purchased or sold on a stock exchange the same way that a regular stock can. An ETF can be structured to track anything from the price of an individual commodity to a large and diverse collection of securities. ETFs can even be structured to track specific investment strategies.

The first ETF was the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index, and which remains an actively traded ETF today.

ETF Summary

• An exchange-traded fund (ETF) is a basket of securities that trades on an exchange just like a stock does.

• ETF share prices fluctuate all day as the ETF is bought and sold; this is different from mutual funds, which only trade once a day after the market closes.1

• ETFs can contain all types of investments, including stocks, commodities, or bonds; some offer U.S.-only holdings, while others are international.

• ETFs offer low expense ratios and fewer broker commissions than buying the stocks individually.

Click Play to Learn More About ETFs

Understanding Exchange-Traded Funds (ETFs)

An ETF is called an exchange-traded fund because it’s traded on an exchange just like stocks are. The price of an ETF’s shares will change throughout the trading day as the shares are bought and sold on the market. This is unlike mutual funds, which are not traded on an exchange, and which trade only once per day after the markets close. Additionally, ETFs tend to be more cost-effective and more liquid compared to mutual funds.

An ETF is a type of fund that holds multiple underlying assets, rather than only one like a stock does. Because there are multiple assets within an ETF, they can be a popular choice for diversification. ETFs can thus contain many types of investments, including stocks, commodities, bonds, or a mixture of investment types. An ETF can own hundreds or thousands of stocks across various industries, or it could be isolated to one particular industry or sector. Some funds focus on only U.S. offerings, while others have a global outlook. For example, banking-focused ETFs would contain stocks of various banks across the industry.

An ETF is a marketable security, meaning it has a share price that allows it to be easily bought and sold on exchanges throughout the day, and it can be sold short. In the United States, most ETFs are set up as open-ended funds and are subject to the Investment Company Act of 1940 except where subsequent rules have modified their regulatory requirements.

Open-end funds do not limit the number of investors involved in the product.

Types of ETFs

Various types of ETFs are available to investors that can be used for income generation, speculation, and price increases, and to hedge or partly offset risk in an investor’s portfolio. Here is a brief description of some of the ETFs available on the market today.

Passive and Active ETFs

ETFs are generally characterized as either passive or actively managed. Passive ETFs aim to replicate the performance of a broader index—either a diversified index such as the S&P 500 or a more specific targeted sector or trend. An example of the latter category is gold mining stocks: as of February 18, 2022, there are approximately eight ETFs which focus on companies engaged in gold mining, excluding inverse, leveraged, and funds with low assets under management (AUM).

Actively managed ETFs typically do not target an index of securities, but rather have portfolio managers making decisions about which securities to include in the portfolio. These funds have benefits over passive ETFs but tend to be more expensive to investors. We explore actively managed ETFs below.

Bond ETFs

Bond ETFs are used to provide regular income to investors. Their income distribution depends on the performance of underlying bonds. They might include government bonds, corporate bonds, and state and local bonds—called municipal bonds. Unlike their underlying instruments, bond ETFs do not have a maturity date. They generally trade at a premium or discount from the actual bond price.

Stock ETFs

Stock (equity) ETFs comprise a basket of stocks to track a single industry or sector. For example, a stock ETF might track automotive or foreign stocks. The aim is to provide diversified exposure to a single industry, one that includes high performers and new entrants with potential for growth. Unlike stock mutual funds, stock ETFs have lower fees and do not involve actual ownership of securities.

Industry/Sector ETFs

Industry or sector ETFs are funds that focus on a specific sector or industry. For example, an energy sector ETF will include companies operating in that sector. The idea behind industry ETFs is to gain exposure to the upside of that industry by tracking the performance of companies operating in that sector. One example is the technology sector, which has witnessed an influx of funds in recent years. At the same time, the downside of volatile stock performance is also curtailed in an ETF because they do not involve direct ownership of securities. Industry ETFs are also used to rotate in and out of sectors during economic cycles.

Commodity ETFs

As their name indicates, commodity ETFs invest in commodities, including crude oil or gold. Commodity ETFs provide several benefits. First, they diversify a portfolio, making it easier to hedge downturns. For example, commodity ETFs can provide a cushion during a slump in the stock market. Second, holding shares in a commodity ETF is cheaper than physical possession of the commodity. This is because the former does not involve insurance and storage costs.

Currency ETFs

Currency ETFs are pooled investment vehicles that track the performance of currency pairs, consisting of domestic and foreign currencies. Currency ETFs serve multiple purposes. They can be used to speculate on the prices of currencies based on political and economic developments for a country. They are also used to diversify a portfolio or as a hedge against volatility in forex markets by importers and exporters. Some of them are also used to hedge against the threat of inflation. There’s even an ETF option for bitcoin.

Inverse ETFs

Inverse ETFs attempt to earn gains from stock declines by shorting stocks. Shorting is selling a stock, expecting a decline in value, and repurchasing it at a lower price. An inverse ETF uses derivatives to short a stock. Essentially, they are bets that the market will decline. When the market declines, an inverse ETF increases by a proportionate amount. Investors should be aware that many inverse ETFs are exchange-traded notes (ETNs) and not true ETFs. An ETN is a bond but trades like a stock and is backed by an issuer such as a bank. Be sure to check with your broker to determine if an ETN is a good fit for your portfolio.

Leveraged ETFs

A leveraged ETF seeks to return some multiples (e.g., 2× or 3×) on the return of the underlying investments. For instance, if the S&P 500 rises 1%, a 2× leveraged S&P 500 ETF will return 2% (and if the index falls by 1%, the ETF would lose 2%). These products use derivatives such as options or futures contracts to leverage their returns. There are also leveraged inverse ETFs, which seek an inverse multiplied return.

How to Begin Investing in ETFs

With a multiplicity of platforms available to traders, investing in ETFs has become fairly easy. Follow the steps outlined below to begin investing in ETFs.

1. Find an investing platform: ETFs are available on most online investing platforms, retirement account provider sites, and investing apps like Robinhood. Most of these platforms offer commission-free trading, meaning that you don’t have to pay fees to the platform providers to buy or sell ETFs. However, a commission-free purchase or sale does not mean that the ETF provider will also provide access to their product without associated costs. Some areas in which platform services can distinguish their services from others are convenience, services, and product variety. For example, smartphone investing apps enable ETF share purchasing at the tap of a button. This may not be the case for all brokerages, which may ask investors for paperwork or a more complicated situation. Some well-known brokerages, however, offer extensive educational content that helps new investors become familiar with and research ETFs.

2. Research ETFs: The second and most important step in ETF investing involves researching them. There is a wide variety of ETFs available in the markets today. One thing to remember during the research process is that ETFs are unlike individual securities such as stocks or bonds. You will need to consider the whole picture—in terms of sector or industry—when you commit to an ETF. Here are some questions you might want to consider during the research process:

3. What is your time frame for investing?

4. Are you investing for income or growth?

5. Are there particular sectors or financial instruments that excite you?

6. Consider a trading strategy: If you are a beginning investor in ETFs, dollar-cost averaging or spreading out your investment costs over a period of time is a good trading strategy. This is because it smooths out returns over a period of time and ensures a disciplined (as opposed to a haphazard or volatile) approach to investing. It also helps beginning investors learn more about the nuances of ETF investing. When they become more comfortable with trading, investors can move out to more sophisticated strategies like swing trading and sector rotation.

How to Buy ETFs

ETFs trade through both online brokers and traditional broker-dealers. You can view some of the top brokers in the industry for ETFs with Investopedia’s list of the best brokers for ETFs. You can also typically purchase ETFs in your retirement account. One alternative to standard brokers is a robo-advisor like Betterment and Wealthfront, which make extensive use of ETFs in their investment products.

A brokerage account allows investors to trade shares of ETFs just as they would trade shares of stocks. Hands-on investors may opt for a traditional brokerage account, while investors looking to take a more passive approach may opt for a robo-advisor. Robo-advisors often include ETFs in their portfolios, although they choice of whether to focus on ETFs or individual stocks may not be up to the investor.

After creating a brokerage account, investors will need to fund that account before investing in ETFs. The exact ways to fund your brokerage account will be depend on the broker. After funding your account, you can search for ETFs and make buys and sells in the same way that you would shares of stocks. One of the best ways to narrow your ETF options is to utilize an ETF screening tool. Many brokers offer these tools as a way to sort through the thousands of ETF offerings. You can typically search for ETFs according to some of the following criteria:

• Volume: Trading volume over a particular period of time allows you to compare the popularity of different funds; the higher the trading volume, the easier it may be to trade that fund.

• Expenses: The lower the expense ratio, the less of your investment that is given over to administrative costs. While it may be tempting to always search for funds with the lowest expense ratios, sometimes costlier funds (such as actively managed ETFs) have strong enough performance that it more than makes up for the higher fees.

• Performance: While past performance is not an indication of future returns, this is nonetheless a common metric for comparing ETFs.

• Holdings: The portfolios of different funds often factor into screener tools as well, allowing customers to compare the different holdings of each possible ETF investment.

• Commissions: Many ETFs are commission-free, meaning that they can be traded without any fees to complete the trade. However, it is worth checking if this is a potential dealbreaker.

 

Examples of Popular ETFs

Below are examples of popular ETFs on the market today. Some ETFs track an index of stocks, thus creating a broad portfolio, while others target specific industries.

• The SPDR S&P 500 (SPY): The “Spider” is the oldest surviving and most widely known ETF that tracks the S&P 500 Index.

• The iShares Russell 2000 (IWM) tracks the Russell 2000 small-cap index.

• The Invesco QQQ (QQQ) (“cubes”) tracks the Nasdaq 100 Index, which typically contains technology stocks.

• The SPDR Dow Jones Industrial Average (DIA) (“diamonds”) represents the 30 stocks of the Dow Jones Industrial Average.

• Sector ETFs track individual industries and sectors such as oil (OIH), energy (XLE), financial services (XLF), real estate investment trusts (IYR), and biotechnology (BBH).

• Commodity ETFs represent commodity markets, including gold (GLD), silver (SLV), crude oil (USO), and natural gas (UNG).

• Country ETFs track the primary stock indexes in foreign countries, but they are traded in the United States and denominated in U.S. dollars. Examples include China (MCHI), Brazil (EWZ), Japan (EWJ), and Israel (EIS). Others track a wide breadth of foreign markets, such as ones that track emerging market economies (EEM) and developed market economies (EFA).

Advantages and Disadvantages of ETFs

ETFs provide lower average costs because it would be expensive for an investor to buy all the stocks held in an ETF portfolio individually. Investors only need to execute one transaction to buy and one transaction to sell, which leads to fewer broker commissions because there are only a few trades being done by investors. Brokers typically charge a commission for each trade. Some brokers even offer no-commission trading on certain low-cost ETFs, reducing costs for investors even further.

An ETF’s expense ratio is the cost to operate and manage the fund. ETFs typically have low expenses because they track an index. For example, if an ETF tracks the S&P 500 Index, it might contain all 500 stocks from the S&P, making it a passively managed fund that is less time-intensive. However, not all ETFs track an index in a passive manner, and may therefore have a higher expense ratio.

Pros

• Access to many stocks across various industries

• Low expense ratios and fewer broker commissions

• Risk management through diversification

• ETFs exist that focus on targeted industries

Cons

• Actively managed ETFs have higher fees

• Single-industry-focused ETFs limit diversification

• Lack of liquidity hinders transactions

Actively Managed ETFs

There are also actively managed ETFs, wherein portfolio managers are more involved in buying and selling shares of companies and changing the holdings within the fund. Typically, a more actively managed fund will have a higher expense ratio than passively managed ETFs. To make sure that an ETF is worth holding, it is important that investors determine how the fund is managed, whether it’s actively or passively managed, the resulting expense ratio, and the costs vs. the rate of return.

Active vs. Passive Equity

Special Considerations

Indexed-Stock ETFs

An indexed-stock ETF provides investors with the diversification of an index fund as well as the ability to sell short, buy on margin, and purchase as little as one share because there are no minimum deposit requirements. However, not all ETFs are equally diversified. Some may contain a heavy concentration in one industry, or a small group of stocks, or assets that are highly correlated to each other.

Dividends and ETFs

Though ETFs provide investors with the ability to gain as stock prices rise and fall, they also benefit from companies that pay dividends. Dividends are a portion of earnings allocated or paid by companies to investors for holding their stock. ETF shareholders are entitled to a proportion of the profits, such as earned interest or dividends paid, and may get a residual value if the fund is liquidated.

ETFs and Taxes

An ETF is more tax-efficient than a mutual fund because most buying and selling occur through an exchange and the ETF sponsor does not need to redeem shares each time an investor wishes to sell or issue new shares each time an investor wishes to buy. Redeeming shares of a fund can trigger a tax liability, so listing the shares on an exchange can keep tax costs lower. In the case of a mutual fund, each time an investor sells their shares, they sell it back to the fund and incur a tax liability that must be paid by the shareholders of the fund.

ETFs’ Market Impact

Because ETFs have become increasingly popular with investors, many new funds have been created, resulting in low trading volumes for some of them. The result can lead to investors not being able to easily buy and sell shares of a low-volume ETF.

Concerns have surfaced about the influence of ETFs on the market and whether demand for these funds can inflate stock values and create fragile bubbles. Some ETFs rely on portfolio models that are untested in different market conditions and can lead to extreme inflows and outflows from the funds, which have a negative impact on market stability.

Since the financial crisis, ETFs have played major roles in market flash-crashes and instability. Problems with ETFs were significant factors in the flash crashes and market declines in May 2010, August 2015, and February 2018.

ETF Creation and Redemption

The supply of ETF shares is regulated through a mechanism known as creation and redemption, which involves large specialized investors called authorized participants (APs).

ETF Creation

When an ETF wants to issue additional shares, the AP buys shares of the stocks from the index—such as the S&P 500 tracked by the fund—and sells or exchanges them to the ETF for new ETF shares at an equal value. In turn, the AP sells the ETF shares in the market for a profit. When an AP sells stocks to the ETF sponsor in return for shares in the ETF, the block of shares used in the transaction is called a creation unit.

Creation When Shares Trade at a Premium

Imagine an ETF that invests in the stocks of the S&P 500 and has a share price of $101 at the close of the market. If the value of the stocks that the ETF owns was only worth $100 on a per-share basis, then the fund’s price of $101 is trading at a premium to the fund’s net asset value (NAV). The NAV is an accounting mechanism that determines the overall value of the assets or stocks in an ETF.

An AP has an incentive to bring the ETF share price back into equilibrium with the fund’s NAV. To do this, the AP will buy shares of the stocks that the ETF wants to hold in its portfolio from the market and sells them to the fund in return for shares of the ETF. In this example, the AP is buying stock on the open market worth $100 per share but getting shares of the ETF that are trading on the open market for $101 per share. This process is called creation and increases the number of ETF shares on the market. If everything else remains the same, then increasing the number of shares available on the market will reduce the price of the ETF and bring shares in line with the NAV of the fund.

ETF Redemption

Conversely, an AP also buys shares of the ETF on the open market. The AP then sells these shares back to the ETF sponsor in exchange for individual stock shares that the AP can sell on the open market. As a result, the number of ETF shares is reduced through the process called redemption.

The amount of redemption and creation activity is a function of demand in the market and whether the ETF is trading at a discount or premium to the value of the fund’s assets.

Redemption When Shares Trade at a Discount

Imagine an ETF that holds the stocks in the Russell 2000 small-cap index and is currently trading for $99 per share. If the value of the stocks that the ETF is holding in the fund is $100 per share, then the ETF is trading at a discount to its NAV.

To bring the ETF’s share price back to its NAV, an AP will buy shares of the ETF on the open market and sell them back to the ETF in return for shares of the underlying stock portfolio. In this example, the AP is able to buy ownership of $100 worth of stock in exchange for ETF shares that it bought for $99. This process is called redemption, and it decreases the supply of ETF shares on the market. When the supply of ETF shares is decreased, the price should rise and get closer to its NAV.

ETFs vs. Mutual Funds vs. Stocks

Comparing features for ETFs, mutual funds, and stocks can be a challenge in a world of ever-changing broker fees and policies. Most stocks, ETFs, and mutual funds can be bought and sold without a commission. Funds and ETFs differ from stocks because of the management fees that most of them carry, though they have been trending lower for many years.1 In general, ETFs tend to have lower average fees than mutual funds.5Here is a comparison of other similarities and differences.

Exchange-Traded Funds	Mutual Funds	Stocks
Exchange-traded funds (ETFs) are a type of index funds that track a basket of securities.	Mutual funds are pooled investments into bonds, securities, and other instruments that provide returns.	Stocks are securities that provide returns based on performance.
ETF prices can trade at a premium or at a loss to the net asset value (NAV) of the fund.	Mutual fund prices trade at the net asset value of the overall fund.	Stock returns are based on their actual performance in the markets.
ETFs are traded in the markets during regular hours just like stocks are.	Mutual funds can be redeemed only at the end of a trading day.	Stocks are traded during regular market hours.
Some ETFs can be purchased commission-free and are cheaper than mutual funds because they do not charge marketing fees.	Some mutual funds do not charge load fees, but most are more expensive than ETFs because they charge administrative and marketing fees.	Stocks can be purchased commission-free on some platforms and generally do not have charges associated with them after purchase.
ETFs do not involve actual ownership of securities.	Mutual funds own the securities in their basket.	Stocks involve physical ownership of the security.
ETFs diversify risk by tracking different companies in a sector or industry in a single fund.	Mutual funds diversify risk by creating a portfolio that spans multiple asset classes and security instruments.	Risk is concentrated in a stock’s performance.
ETF trading occurs in-kind, meaning they cannot be redeemed for cash.	Mutual fund shares can be redeemed for money at the fund’s net asset value for that day.	Stocks are bought and sold using cash.
Because ETF share exchanges are treated as in-kind distributions, ETFs are the most tax-efficient among all three types of financial instruments.	Mutual funds offer tax benefits when they return capital or include certain types of tax-exempt bonds in their portfolio.	Stocks are taxed at either ordinary income tax rates or capital gains rates.

 

Evaluating ETFs

The ETF space has grown at a tremendous pace in recent years, reaching $4 trillion in invested assets by 2019.6 The dramatic increase in options available to ETF investors has complicated the process of evaluating which funds may be best for you. Below are a few considerations you may wish to keep in mind when comparing ETFs.

Expenses

The expense ratio of an ETF reflects how much you will pay toward the fund’s operation and management. Although passive funds tend to have lower expense ratios than actively managed ETFs, there is still a wide range of expense ratios even within these categories. Comparing expense ratios is a key consideration in the overall investment potential of an ETF.

Diversification

Nearly all ETFs provide diversification benefits relative to an individual stock purchase. Still, some ETFs are highly concentrated—either in the number of different securities they hold or in the weighting of those securities. A fund that concentrates half of its assets in two or three positions may offer less diversification than a fund with fewer total portfolio constituents but broader asset distribution, for example.

Liquidity

ETFs with very low AUM or low daily trading averages tend to incur higher trading costs due to liquidity barriers. This is an important factor to consider when comparing funds that may otherwise be similar in strategy or portfolio content.

What was the first exchange-traded fund (ETF)?

The first exchange-traded fund (ETF) is often credited to the SPDR S&P 500 ETF (SPY) launched by State Street Global Advisors on Jan. 22, 1993. There were, however, some precursors to the SPY, notably securities called Index Participation Units listed on the Toronto Stock Exchange (TSX) that tracked the Toronto 35 Index that appeared in 1990.

How is an ETF different from an index fund?

An index fund usually refers to a mutual fund that tracks an index. An index ETF is constructed in much the same way and will hold the stocks of an index, tracking it. However, an ETF tends to be more cost-effective and liquid than an index mutual fund. You can also buy an ETF directly on a stock exchange throughout the day, while a mutual fund trades via a broker only at the close of each trading day.

How many ETFs are there?

The number of ETFs, along with the amount of assets that they control, has grown dramatically over the past two decades. In 2020, there were an estimated 7,602 individual ETFs listed globally, up from 7,083 in 2019—and only 276 in 2003.

How do ETFs work?

An ETF provider creates an ETF based on a particular methodology and sells shares of that fund to investors. The provider buys and sells the constituent securities of the ETF’s portfolio. While investors do not own the underlying assets, they may still be eligible for dividend payments, reinvestments, and other benefits.

How to invest in ETFs?

Because shares of ETFs trade like stocks, the most common way for individual investors to buy and sell ETFs is through a broker. Brokerage accounts allow investors to make ETF trades manually or through a passive approach such as a robo-advisor. Investors choosing to have a more hands-on approach will need to search through the growing ETF market for funds to buy, keeping in mind that some ETFs are designed for long-term investment and others are designed to be bought and sold over a short period of time.

What is an ETF account?

In most cases, it is not necessary to create a special account to invest in ETFs. One of the primary draws of ETFs is that they can be traded throughout the day and with the flexibility of stocks. For this reason, it is typically possible to invest in ETFs with a basic brokerage account.

What does an ETF cost?

ETFs have administrative and overhead costs which are generally covered by investors. These costs are known as the “expense ratio,” and typically represent a small percentage of an investment. The growth of the ETF industry has generally driven expense ratios lower, making ETFs among the most affordable investment vehicles. Still, there can be a wide range of expense ratios depending upon the type of ETF and its investment strategy.