Stocks, ETFs and Mutual Funds Explained Simply
We recently compared Tax-Free Savings Accounts (TFSAs) and Registered Retirement Savings Plans (RRSPs) to a grocery cart or basket at a supermarket. This week we’ll be looking at stocks, exchange-traded funds (ETFs) and mutual funds. We’ll stay in the supermarket for this week’s analogy and move to the fresh produce aisle.
Purchasing stocks
A stock represents your partial ownership of a company. You can buy stocks from other investors through a stock exchange, which is a digital market. If you’d like, you can pick and choose which companies you want to invest in. Perhaps you want to own shares in ten companies that you’re familiar with (e.g., McDonald’s, Costco, Microsoft). Picking an individual stock is like going to the supermarket and purchasing individual fruits. To be sure you’re getting a fair deal for your produce, you’ll likely need to know:
which fruits are in season
when a fruit is ripe
the price compared to historical prices
With stocks, instead of worrying about ripeness, you’d be focused on the company’s business model and the likelihood it will earn a profit in the future. When buying individual stocks, you’d likely need to know:
what the company owns and owes
how much it earns
the price of the stock compared to historical prices
Whether you’re buying individual stocks or fresh produce, there’s a risk you could make a sour pick. If you buy a single cantaloupe and get home to find out it’s gone bad, you’ll have nothing to pair with dessert. Similarly, if you invest in only a few stocks, and one of the companies starts performing poorly, you could lose a large portion of your money.
Purchasing exchange-traded funds (ETFs)
Instead of buying individual stocks, you can buy an exchange-traded fund (ETF) that bundles a list of stocks together for you. Think of an ETF as a fruit salad. Rather than searching for in season and ripe produce, you can buy a prepared snack that’s ready to go. ETFs take hundreds of stocks and combine them into a single investment. This way, if an individual stock falls in value, the remainder can make up for the loss, and your savings can continue to grow. Similarly, while a fruit cup may have a bad piece of pineapple, the rest of the snack can meet your needs.
You can buy and sell ETFs through a stock exchange, the same way you would a stock. In North America, stock markets are open from 9:30 am to 4:00 pm ET Monday to Friday, aside from major holidays. You can buy and sell ETFs at any time during this period. This is similar to your ability to buy produce or fruit salads during your local supermarket’s store hours.
Purchasing mutual funds
A mutual fund is very similar to an ETF except for two major differences.
Mutual funds can’t be bought and sold throughout the day as ETFs can.
Often, mutual funds can only be bought or sold at the end of each day. As a result, you won’t know the exact price you’ll pay for your mutual fund ahead of time. If you’re investing on a long-term basis, this has little impact.
The fee that mutual funds charge is often partially paid to an advisor on your behalf.
Both ETFs and mutual funds charge you a fee, which we’ll discuss more shortly. However, with mutual funds, this fee is often higher and partly used to pay the financial planner or financial advisor who helped you purchase the mutual fund. It’s vital that you know how much the mutual fund is charging you, who’s receiving the money and whether it’s worth it for you.
Management expense ratio (MER)
The most important aspect of purchasing an ETF or mutual fund is the added cost. When you buy a fruit salad at the store, you’ll pay a bit extra because someone had to choose the fruits, prepare them and package them. Similarly, ETF and mutual fund providers will charge you a fee to select and bundle stocks together. This fee is called the management expense ratio (MER), and it can significantly impact your investment returns. Some funds charge a fee of 0.1%, costing just $50 a year if you invest $50,000. Other funds charge 2% or more, costing $1,000 or more each year on a $50,000 investment. The following table outlines how much you pay each year, depending on the amount you invest and how much the MER is.
Because there’s minimal impact of fees in the early stages of investing, your focus should be on getting started and saving as much as you can. Once you’ve built up a larger balance, it’s critical to only pay fees if the services you’re receiving are worth it.
Passive vs. active funds
The two main factors that determine whether you pay 0.1%, 2% or somewhere in between are:
Whether an advisor is being paid on your behalf (as often happens with mutual funds).
How the fund manages selecting and bundling stocks.
There are two ways a fund can select and bundle stocks for you:
Passively
They follow a set list with minimal research and minimal buying or selling.
Actively
They research individual companies and regularly buy and sell stocks.
The more active the management team is the higher their fees. The MER goes to pay for analysts that research companies and all the overhead associated with running the business.
Coming back to your fruit salad, if the clerk who prepared it followed a set recipe, he took a passive approach to your snack. He followed a pre-set list of ingredients and therefore didn’t need to do any research on the best fruit pairings. On the other hand, if your fruit salad was prepared by a gourmet chef who walked through the produce aisle choosing the finest ingredients, then it was prepared through an active approach.
One important caveat is that while a chef is likely able to know what fruits are in season and what pairings work, this is not the case with investments. There is evidence that most funds that actively manage your money perform worse than passive funds. It’s hard for fund managers to earn a high enough return to offset their 2% fees on a regular basis. This is mostly because the stock market is so unpredictable, and there are so many ‘gourmet chefs’ picking over the produce daily.
Closing remarks
As we’ve now covered, stocks, ETFs and mutual funds are very similar. They allow you to buy partial ownership in companies to help grow your money at a faster rate. The main benefit of ETFs and mutual funds is their ability to purchase a broad bundle of stocks on your behalf, also called diversification. The main downside of ETFs and mutual funds is the fee you pay on an ongoing basis.
It’s worth reflecting occasionally on whether the fees you’re paying are worth the simplicity the fund adds or the value your advisor brings. If you’re ready to take the next step and start investing, here’s a 7 step guide.