Stocks, Mutual Funds, or ETFs —Uh?

Do you want to start saving by investing in the stock market? Are you, for the first time, tasked with making decisions about your investment dollars? Then this guide is for you. For someone relatively new to choosing what to invest in, sifting through the many different options can be overwhelming. But don’t pull out your hair in frustration, or throw up your hands in surrender. A financial advisor can shepherd you through the maze of stock investing choices. This guide can help you get started.

Interpreting the mumbo jumbo

The stock market, often referred to as the equity market, offers several ways to invest. Investors can buy shares in an individual company stock, or they can buy a slice of a pool of stocks alongside other investors.

When someone buys a stock, they are buying a portion of a company, and they become an owner of that company. Most stocks have hundreds or thousands of owners, and typically investors own a tiny fraction of a company. When you buy a stock, the price you pay is subject to how well the company is run and how much money—profit—it makes. Stock investors participate in a share of the company’s profits, paid through dividends (a quarterly cash payment), and capital appreciation, or growth in the stock’s price.

Stocks are bought and sold throughout the day on a stock exchange, like the National Association of Securities Dealers Automated Quotation System (Nasdaq) or the New York Stock Exchange (NYSE), and their prices can fluctuate greatly depending on how much demand there is for that stock. Demand is often driven by how much money the company makes, news stories, and the overall health of the general economy.

Sometimes, experiencing fluctuations in one single stock is too stressful for an investor. Other times, they’d like to buy more than one stock but don’t have enough capital. In these cases, investors often turn to pooled vehicles, where they buy shares in a basket of stocks. Mutual funds are an example of this way to invest. There’s also exchange-traded funds (ETFs), which are a hybrid, having characteristics of both individual stocks and mutual funds.

A mutual fund is a pooled investment vehicle—meaning many investors “pool” their money together in a single fund. Mutual funds hold a basket of many different securities, allowing fund holders to buy into the pool, instantly gaining exposure to lots of stocks more cheaply than owning each stock outright, and diversifying the risk of only owning a single stock. Unlike when an investor buys shares of an individual company, however, when buying into a mutual fund, he/she does not decide which individual stocks are held in the basket. This basket of securities is managed by a professional money manager who can passively track an index, which is a basket of securities that represents the broad market it attempts to replicate, or actively choose individual securities.

An exchange-traded fund is similar to a mutual fund in that it invests in a basket of securities. However, they generally passively follow an index, although there are a few actively managed ETFs. And unlike a mutual fund which trades only once a day, ETFs trade on a stock exchange throughout the day, so investors can buy or sell at any time, just like a stock. This intraday trading allows investors to know the price of their investment at any point in time, whereas mutual fund prices are only known after the market closes for the day.

What’s the cost?

There are many pros and cons to investing in these three types of securities. In the following display we highlight a few typical benefits and considerations, although some may have characteristics that differ from these generalizations.

 

Overwhelmingly, many investors are concerned about the cost of making the investment. For stocks, the cost of using an online platform is straightforward: It is usually a one-time commission charged for the total transaction, typically regardless of the number of shares bought or sold.

ETFs also have this transaction cost, although there are a few that trade for free. But ETFs also charge an expense ratio. The expense ratio is a fee for managing and operating the fund. Passive funds have very low expense ratios, whereas active funds charge more. Mutual funds also charge an expense ratio, but because the operating costs tend to be higher than with ETFs, expense ratios are also higher.

The tax impact from investing in these securities also needs to be considered. All are subjected to capital gains taxes, but they are not equally tax efficient. If individual stocks are held longer than one year and are sold for a gain, investors pay long-term capital gains. If they are sold earlier than one year, they are taxed at the higher short-term capital gains rate. Sometimes, if stock prices are lower than what the investor paid, they can be sold at a loss to offset capital gains on other securities. ETFs are treated the same way. Mutual funds, however, have an extra wrinkle. Mutual fund managers pass through the capital gains to the fund’s shareholders annually. The shareholders cannot decide on the length of time to hold the basket of securities or whether to use losses to offset gains. Therefore, mutual funds can be less tax efficient for the investor.

Ready, set, invest

Fees—commissions or expense ratios, for example—and taxes reduce the returns on equity investments. Therefore, regardless of the type of equity, before investing, investors need to do some homework. A financial advisor can help, but it’s also important for the investor to understand why an investment may make sense. Some aspects to consider include:

• Compare performance, net of fees, and look at the volatility of past returns—if returns were very high one year, but negative for the next two years, then the investor should investigate why.
• Review the management team—the investment professionals managing the mutual fund or ETF, or the company’s officers--to ensure they are the same team that produced prior period results.
• Check to see if a fund’s investment process was altered or a company had a material change to their operations.

All funds have a prospectus, and individual companies have annual and quarterly reports (10K and 10Q forms) that provide this detailed information. These reports can be found on the SEC’s website.

We’ve all heard the disclaimer, “Past performance does not guarantee future results,” which is true, but by doing your homework, you will make an intentional, informed decision.

For more tips on becoming financially engaged, explore Women & Wealth, a new Bernstein podcast series designed to educate, empower, and inspire female investors, and for additional thought leadership, check out the related blogs here.