19. Investing Basics Part 3 - Mutual Funds and ETFs

Transcript:

Hello, and welcome back to the Canadian Money Roadmap podcast. I'm your host Evan Neufeld. Today we are in part three of our investing basics series and we're going to be talking about Mutual funds and ETFs. I'm going to explain what they are, some of the differences between them and some of the costs associated with them.  Along with that, some of the misconceptions that people might have about one or the other, so that way you can make a decision that's most appropriate for you. 

Like some of the more recent podcasts here in our investing basics series, anything that I talk about today will not be a recommendation of one thing or the other. I just want to explain how they work so you can start to do your research a little bit more effectively, and you can determine what types of investments are appropriate for your situation.   

I mentioned off the top, this is Mutual Funds and Exchange Traded Funds. Exchange Traded Funds are often known as ETFs, I’ll just keep using ETFs as the acronym here.  

So what are these things? Well, I'll backtrack a little bit back to part one and part two where I talked about stocks and bonds. Stocks and Bonds take a lot of money to purchase them and especially in the case of bonds, it's really hard to actually buy them with a small amount of money. So use the example of one share of Amazon. So today, as of this recording, if you wanted to buy a piece of Amazon, it would cost you about $3,000 US. So that's a lot of money, especially if you're just getting started.  So if you only had $3,000 to invest, you could only buy one share of one company. So you wouldn't have a very diversified portfolio.  

So just in general, if you need a lot of money to make a specific investment, diversification is going to be really difficult for you. So that's where mutual funds and ETFs come into play. 

Mutual funds and ETFs are just investments that pool people's money together to allow them to buy groups of stocks and bonds, and sometimes other types of investments. So myself and someone down the street and 500 other people, all of the money comes together. And then that creates a pool of money that has more purchasing power than just my own. 

So, because I'm only contributing my portion and someone else contributes their portion. We only buy a little sliver of that mutual fund or the ETF. So if the goal is the same between the two. it's to provide easy access to a large group of investments or what we call securities.  Securities would be stocks and bonds. 

So it provides easy access to a large group of securities for investors of all sizes. Sometimes these pools or funds are specific to an investment style or a sector of the market, or even just a general group of the market as a whole. There's thousands of different options available. So if the goal is the same, how are mutual funds and ETFs different? 

Here's the first misconception. Many people think that mutual funds are what we call “actively managed” and ETFs are “passively managed”. If you don't know what that means, don't worry about it for now, but this is again a misconception. It's not necessarily the case. However, there are more passive ETFs than there are passive mutual funds, but that just, isn't a key difference between the two. 

The main one is that they simply have a different structure that affects how an investor buys them. And so with a mutual fund, it's easier to invest a specific amount of money because you can own fractions of a mutual fund unit. So for example, if you had a thousand dollars to invest, you could buy a thousand dollars worth of mutual fund units. 

Whereas ETFs are more like stocks. There's a set price per unit. And you can buy as many units as your budget allows, but it won't necessarily be the specific dollar amount you had in mind. 

So there are some emerging platforms that allow people to own fractions of an ETF, but that's not exactly widespread yet. And it's kind of new. 

The second difference comes down to how you purchase them and how much it costs to purchase them. So depending on where you're buying and selling mutual funds and ETFs, there might be trading commissions associated with them. More often than not because ETFs are treated like stocks, they would have a similar type of commission structure depending on the platform you use. 

So there might be a transaction cost to purchase an ETF. Mutual funds can have transaction costs as well, but because mutual funds are typically bought and sold through an investment advisor, just talk to them to see if there are any transaction costs. This is something that's changed over the years, and it is far less common to have a fee for purchasing them these days, but just double check before you make that purchase.  

The third difference is related to how the prices change. So again, because an ETF or exchange traded fund is traded on an exchange, just like a stock would be traded on exchange. The price of that ETF fluctuates every second of the day, while the market is open. Whereas a mutual fund, it has one price at the end of the day. 

This isn't necessarily an advantage or a disadvantage, unless you want to be trading minute by minute with your ETFs. But I obviously don't recommend that you do that, but just so you know how the price is set for each of those things. 

The next difference comes to how distributions work. So distribution, you can think of them like dividends. Most people are familiar with that term dividend where if you own an investment and it pays the investor or the owner a little bit of money. We call those distributions when we're dealing with funds. 

I won't get into the reasons why but think of it similar to like a dividend. So with a mutual fund, because you can own those fractions of a share. Those distributions often are automatically reinvested whenever they happen. Sometimes it's monthly. Sometimes it's annual. Sometimes it's not at all, but when a distribution happens, it's typically reinvested and you get that many more shares to own automatically. 

ETFs it's possible for this to happen, but each ETF that you own has to have something called a drip or a dividend reinvestment plan or distribution reinvestment plan.  Just like when you're making that initial purchase, if the distribution allows you to buy whole units, meaning it's enough dollars. So if you have a distribution of $50 and your unit price is $50, your distribution could purchase an additional unit of the ETF. But sometimes it can't, so it'll often be paid to you in cash.  So you'll build up a little bit of a cash balance instead of more units in the fund. 

We'll come back to this in a quick second here, but just to briefly mention it, the structure of ETFs allows them to typically have lower management costs. It's not a universal truth, but some ETFs are very low cost, but because a lot of the convenience factors of mutual funds, their cost is sometimes higher than a comparable ETF. 

So as a result of that, where ETFs might have some transaction costs, you can't necessarily buy a specific dollar amount. ETFs are often best suited for lump sum investments, especially if you're incurring those transaction costs. Whereas mutual funds are often best suited for making regular contributions.  So if you'd like to invest a hundred dollars every two weeks or something like that, mutual funds are really good option there.  

So because of some of those differences you might have seen or you might find in your research mutual funds of ETFs. Sometimes we call those a fund of funds. Now this is a bit of mental gymnastics that you have to get over here, but it creates bit of a best of both worlds scenario. 

So it has a lower average cost of the ETFs with the flexibility of mutual funds that allows people to buy and sell them more affordably and buy fractions of units. So let's talk about those costs again, the misconception that most people have is that ETFs are always cheaper, but because of those other types of costs that might be incurred along with them, you might pay fees in other ways that you might not be realizing. So for any type of pooled investments like mutual funds or exchange traded funds, there are costs associated with them. 

I mentioned the trading commissions before, and that's just the cost of buy and sell. These may or may not exist depending on where you buy, but you always want to know.  If something is advertised as free, they might be charging you in a hidden cost somewhere along the way. So just be careful about that. 

So that's the cost of buy and sell, but there is also cost to own them because there's cost to operate these funds. So these are known as management fees. So just like with your own budget, you won't necessarily know what they are until they happen. So management fees are what the costs were in the past, not necessarily what they'll continue to be in the future. It’s probably pretty close, but it's worth knowing that it's a backward looking number. So these management fees you might've heard of MER before or management expense ratio. Now, like our industry needs more acronyms, but essentially this just means what were the expenses compared to the assets. 

Okay. So if you use an advisor or broker to purchase investments, there's a portion that's paid to them for the service. And it's often included in the Mer. Sometimes it isn't, sometimes it's split out, but sometimes it is. So your Mer might appear to be higher, but you just have to know what you're actually paying for along with that MER, if you're buying your own investments, make sure you're buying the correct version of that fund that does not include an advisor fee. You don't need to pay for a service you're not receiving. 

So back to my mention of passive versus active. The easiest way to explain that, So if a computer algorithm picks the investments, typically this management expense will be cheaper. But if a human team of professionals pick them, they'll typically be more expensive, but cheap doesn't always mean better.  Fees are one factor to consider when making an investment.  

So, because I mentioned before how there are thousands of different ETFs and mutual funds and some of them are based on style and different risk profiles and different types of investments. You want to make sure that you know what you're investing in and not just looking for the cheapest product, because that might not necessarily be appropriate for your timeline or for your risk preference or things like that.  So historical returns, investment style, historical volatility, investor preferences, they'll all be important factors to help you determine which is appropriate for you.  

Here's a little side note here. If a company or mutual fund or ETF provider, investment firm, or even an advisor is talking about beating the market or consistently beating its competitors or making you richer, you'll want to look very closely at what is going on. 

Especially if that firm is talking about how low their fees are, you want to double check to make sure that the returns they advertise actually include the fees they do charge. Sometimes I've seen companies advertise “low fees”, but these low fees are fees that no other investments would even charge at all.  So sometimes low fees can be a cover for other costs. 

Keep in mind that every time you purchase an investment, you are purchasing them from a business that's also trying to make money and unless you're buying an investment from a charity, there will be costs associated with them. So a good phrase that I picked up when I was studying economics was there's no such thing as a free lunch. 

So as soon as someone seems to be advertising a free lunch, just be careful. Another thing here is if say a hypothetical company says you can retire 30% wealthier by using their product, you should approach that with an appropriate level of skepticism and make sure you do your research on the alternatives before investing. 

Costs, long-term performance, history, volatility, and other risk measures would all be important factors to consider and not just what an actress says on a commercial. So just to summarize mutual funds and exchange traded funds, or ETFs are two tools that help people invest money in diversified portfolios. 

Their structures are quite different, but the goal is the same: easy access to a large group of securities for investors well sizes. 

Thanks for joining me today on the Canadian Money Roadmap podcast. If you enjoyed today's episode, I'd really appreciate if you left me a review on Apple podcasts with your biggest takeaway. If you have questions or ideas for topics you'd like me to discuss on future episodes, please reach out via my contact info in the show notes. 

This podcast is intended to be educational in nature, and you should always consult your Financial team, Tax and legal advisors before making changes to your financial plan. Any rates of return discussed are historical or hypothetical and are to be used for educational purposes. Evan Neufeld is a a Qualified Associate Financial Planner and Registered Investment Fund advisor. Mutual funds are provided through Sterling Mutuals Inc.