Investors often use index funds to diversify. These are typically mutual funds or exchange-traded funds, or ETFs.
All three investments pool stocks and bonds or other holdings into a single fund. So, for example, instead of owning $100 worth of just Amazon or Microsoft stock individually, you’d own $100 worth of shares in numerous technology companies.
But mutual funds and ETFs work in a slightly different way.
Here’s a quick explainer:
As their name implies, ETFs are investment funds that are traded on an exchange, such as the New York Stock Exchange (NYSE) or NASDAQ.
ETFs often correspond to a particular size of company, industrial sector, market, or even social goal. So, you could own shares in an ETF that owns blue chip stocks of large companies, or the stocks of less well-known, smaller companies.
You could also purchase shares of ETFs that specialize in emerging markets, commodities, or consumer products, to name a few different options. An ETF might also invest in companies that are helping the environment or working to increase fair labor practices overseas.
- You don’t own the stocks held by an ETF directly, instead you own shares of the fund, which in turn owns securities of different companies.
- ETFs can also be index funds (See below).
Like an ETF, a mutual fund is also a basket of stocks that focuses on a sector, geography, or company size, among other things.
You own shares in a mutual fund as well, but the share price is calculated at the end of the day. By contrast, ETFs have share prices that fluctuate throughout the day, and they can be bought and sold throughout the day like individual stocks.
- Mutual funds are managed by professionals, who charge fees for their services.
- Mutual funds can also be index funds (See below).
ETFs and mutual funds can also be index funds.
These funds follow specific indexes, such as the Dow Jones Industrial Average, which reflects the stock prices of some of the 30 largest publicly traded companies in the U.S., or the NASDAQ, where most technology stocks are traded–think Amazon and Facebook.
- Generally speaking, index funds are passively managed, which means investment decisions are made according to index rules. (The fund essentially invests in the same stocks as the index.)
- Because index funds are passively managed, the fees they charge tend to be lower than actively managed funds.
Generally speaking, the overall operations of an ETF are more tax-efficient than mutual funds. It’s a little complicated, but both ETF and mutual fund managers buy and sell shares of companies on a regular basis, depending on a host of factors, such as company performance.
Due to the way ETFs are structured, they sell shares in a manner that triggers fewer taxes.
When it comes to investing, you never want to put all your eggs in one basket.
You’re better off diversifying, which means spreading out the cash you plan to invest in a variety of stocks, bonds, or other holdings.
The theory is that diversification can reduce your financial risk. That’s because the value of any single stock or bond can increase or decrease suddenly, depending on what’s going on in the markets, or the broader economy.
If that single stock drops precipitously, the value of your investment can be wiped out. A basket of stocks, potentially, won’t be subject to swings in value that are as big.
- ETFs can help you diversify, or spread out the risk, of your portfolio.
- An ETF owns a basket of securities of different kinds of companies, industrial sectors, or geographies.
- ETFs tend to have lower costs than mutual funds.
Recommended Reading: What’s a Fiduciary? Why Does It Matter?
Jeremy Quittner is the financial writer for Stash.