One of my key goals for 2019 is to figure out what I should be doing with my money (aside from making monthly payments to my student loans – shoutout to my fellow lawyers, #foreverindebt). If you’re in the same boat, or just trying to figure out some basic financial goals for a savvy young professional, join me for the ride!
In my Money Talks series, I’m going to be right there with you, figuring out financial literacy for non-experts who just want to be smart about their hard-earned cash.
If you’ve read literally anything to do with the financial industry lately, or happened to catch a Wealthsimple commercial before watching yet another makeup tutorial on Youtube (…I’m projecting here), then the first question you probably have is “What on earth is an ETF? Is that the same thing as mutual funds, those things I always see pamphlets about in my bank branch? How are we supposed to learn this stuff anyway? Why didn’t they teach me this in highschool, instead of advanced calculus?”
There are plenty of detailed resources you can read about beginner finance (and I’ve listed some below, if you want to really become an expert in this stuff), but today’s war between mutual funds and ETFs can be boiled down to some pretty simple points.
First Thing’s First – What are These Things?
Let’s start off real basic here. ‘Investing’ basically means buying something and letting it sit there for a while, hoping it goes up in value so that you can make a profit when you eventually sell it. Basically, the goal of investing is (usually) just to make the money that you initially used to buy whatever product, make more money for you by making you a profit later on.
So what do people invest in? Well you probably know that some people invest their money in stocks, bonds, blah, blah, blah… The point is, there are a bunch of products you can buy (invest in) with your money. Two of these kinds of things are (1) Mutual Funds and (2) Exchange-Traded Funds, also known as ETFs.
Mutual Funds and Exchange-Traded Funds both have the word ‘funds’ in the name. So what’s the difference?
Picture a big basket holding a bunch of little things. That’s basically all a ‘fund’ means.
The ‘basket’ is the fund. The things being held in the ‘basket’ of a fund are (usually) shares of different companies.
The fund owns and regularly buys and sells a bunch of securities or stocks (meaning, small pieces of ownership of a company) in a bunch of different companies, which then goes into the fund’s ‘basket’.
Long story short, when you put your money into a fund, you’re basically buying a teeny, tiny piece of ownership of the basket and everything sitting inside it. That’s the difference between owning a piece of a fund (a piece of the basket, including all of the different stocks in it) vs buying a single stock.
So what’s the Difference between Mutual Funds and ETFs?
A mutual fund is just a big ‘basket’ of whatever securities the manager of the fund (meaning: whoever or whatever company runs and manages the fund) decides to put inside the mutual fund’s basket. Whatever that manager puts into the basket is what you own when you buy a piece of the basket. The selection can be anything that the manager, using its best judgement, decides is a good mixture.
In contrast, the ‘basket’ of an ETF will (usually) only hold stocks in all of the companies listed on a specific stock market or specific industry (meaning: a basket holding a mixture of companies who are all listed on the S&P 500 Index [a stock market], or who are all in the energy industry or restaurant industry, etc.).
Don’t worry, we’re almost done with the heavy stuff. Stick with me because the promised land arrives in a couple of paragraphs.
What I’m saying is, the purpose of ETFs is basically to mimic the same value as a big group of companies that are all listed on the same stock index or exist in the same industry. Remember that stock exchanges go up and down in value on a daily basis – sometimes by a little, sometimes by a lot. Thus, the money you invest in an ETF is going to go up and down in value as well according to that same stock exchange or industry value.
The value of mutual funds will also go up and down, but remember that the bundle of stocks in a mutual fund isn’t designed to be a copy of all the stocks in a specific stock index – it’s just a bundle of stuff put together by the manager at his/her/its discretion. You could have restaurant companies and oil companies on a bunch of different stock exchanges, all in one mutual fund basket – which isn’t how ETFs work.
Still with me? Breathe. The hard part is over. It’s time for the good stuff.
Basically every investing book will tell you that for the average person, fees will make or break your portfolio. Even half a percent (as in 3.5% fees vs 3% fees) can add up to hundreds of thousands of dollars of difference in total profits over the course of your investing career.
Because fees eat into the amount that you eventually get back from your initial investment.
Here’s an example. Let’s say your initial investment goes up in value by 5% but you’re paying 3% in fees. This means the profit you take home on your investment value is reduced to 2% (because they took 3% in fees away from your 5% value increase).
Even worse, a lot of mutual funds charge you these fees whether or not the fund actually increases in value. That means you may have to pay the 3% fee even though your investment value stayed the same, or declined in value. Let’s say the value of a fund decreased by 2% one year and you still have to pay 3% of your investment in fees. That means you’re losing money to your fees!
So, because of what I just explained, one of the most important factors in choosing between mutual funds and ETFs are obviously the fees associated with both. You can find these in the “Fund Facts’ documents that you get when you’re about to purchase an ETF or mutual fund. If you can’t find them, request them. MAKE SURE YOU CHECK ALL THE FEES ASSOCIATED WITH THE FUND YOU ARE CONSIDERING PURCHASING.
So what’s the solution to this mega problem? The general advice around town is:
Paying less in fees = keeping more of your returns when your investment increases in value = more money in your (eventual) pocket.
Crazy, I know. Remember how I said even a minor difference in fees can make a dramatic difference in your investments over a long period of time? Mutual funds usually have higher fees than ETFs (but make sure you confirm this by comparison before you go out and buy anything). This makes ETFs a pretty attractive option for the average investor who doesn’t have a huge net-worth, because otherwise fees might eat up most of your gains in the market. Paying high fees usually means you’re making money for your mutual fund managers, but not necessarily for YOU.
There are definitely other differences between these products and other factors that affect how you can generate wealth through investments (again, check out the links below for more information), but one of the most important differences between mutual funds and ETFs, from your perspective, should be the fees that it costs to buy and stay invested in the product.
You made it to the end of the article! I’m proud of you for sticking with it. I’m going to cover more financial topics (RRSPs, TFSAs, credit card debt, student loans) in my Money Talks articles, so make sure to come back and check them out if you found this article helpful! If you want to ask me to cover a specific topic, reach out to me here or on Instagram!
If you want to learn more about investing, read through some of the articles provided by the Ontario Securities Commission on things like The Different Kinds of Mutual Fund, Investing Basics and Investing Risks. They give a way more fulsome picture than I can describe here on a small, personal blog.
Disclosure: This article is meant to provide basic, general information and does not provide any kind of legal, financial, or professional advice. Always contact a qualified and/or licensed professional for any personal or specific advice you may be seeking.