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You’ve probably heard before that diversification is important for nearly any portfolio. But how do you get it?
Many individual investors have limited funds and therefore a limited number of stocks or other assets they can buy to diversify. Luckily, this is why mutual funds and exchange-traded funds (ETFs) exist.
The Mutual Fund
ETFs and mutual funds both serve a similar purpose, but they’re also different. Mutual funds are a pool of assets managed by investment professionals with a specific investment objective in mind.
These funds can contain stocks, bonds, short-term money market instruments or even a balance of different asset types. The manager writes in the fund prospectus the investment guidelines he or she plans to follow, as well as past performance and other pertinent data.
Mutual funds have existed since the late 19th century, and they are currently regulated by the SEC. Although they require management fees and some require fees to enter and/or exit the fund, mutual funds offer diversification because an investor can buy one mutual fund share that represents the performance of a pool of possibly thousands of assets.
The Exchange-Traded Fund
The ETF differs from mutual funds in that they often track an index such as the S&P 500. Indexes can represent entire markets, but they are not managed by investment professionals in a dynamic way.
For instance, the Barclays Capital Aggregate Bond Index represents almost all investment grade bonds being traded in the US. Although no one can invest directly in an index such as this, ETFs track the performance of these indexes and you can invest in those. For this index, iShares offers an ETF to track the Barclays Capital Aggregate Bond Index with ticker AGG.
Although ETFs can be more static than mutual funds, you know exactly what you’re investing in and this will not change due to the vagaries of the investment manager. It can also offer high diversification depending on the ETF chosen.
Which to Choose?
ETFs are often cheaper than mutual funds because management fees are low or non-existent for ETFs. ETFs also trade like stocks on exchanges, so they can be shorted or bought on margin. However, most ETFs do not have the benefit of active management.
For investors looking for diversification, the choice between mutual funds and ETFs will come down to the objective. Are you looking for a manager to make the decisions, or are you confident enough to choose which indexes you wish to invest in?
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See this post in its original form at Kapitall.com.