ETFs vs. Mutual Funds and How You Can Diversify Your Portfolio
In this post I’m going to cover the basics of ETFs (exchange-traded funds) and mutual funds. This article will be broken down into the following segments
- What is an ETF?
- What is a mutual fund?
- What are the differences and similarities?
- How can I use ETFs and mutual funds to diversify my investments?
What is an ETF?
ETF stands for “exchange traded fund”, meaning that they are traded on popular stock exchanges, such as the NASDAQ or NYSE, and you can purchase them like you would purchase a stock of some company.
When you purchase a share of an ETF you’re essentially buying a portion of a larger fund. The fund can contain many different securities: stocks, bonds, commodities (oil, gold, grain, natural gas, etc.).
Let’s take a look at an ETF called SCHX (Schwab US Large Cap ETF) – which you can purchase using your brokerage account for $80.39 at the time of writing this article. The overall “basket” of stocks in this ETF is valued at around $22 billion. Of the $22 billion, we can look at how the money is split up in that ETF.
| Company | Portion of Fund |
| Apple Inc | 6.01% |
| Microsoft Corp | 5.35% |
| Amazon.com Inc | 4.40% |
| Facebook Inc A | 2.14% |
| Alphabet Inc A | 1.49% |
| Alphabet Inc Class C | 1.45% |
| Berkshire Hathaway Inc Class B | 1.35% |
| Johnson & Johnson | 1.30% |
| Visa Inc Class A | 1.10% |
| Procter & Gamble Co | 1.10% |
| JPMorgan Chase & Co | 1.01% |
| UnitedHealth Group Inc | 1.00% |
| The Home Depot Inc | 0.97% |
| Mastercard Inc A | 0.96% |
For example, of the 22 billion in the ETF, 6% of that, or 1.32 billion dollars, is invested in Apple stock.
This ETF is in the category of US large-cap blend, meaning that it consists of a blend of U.S. companies that have a large market capitalization. So when you purchase this ETF, you gain exposure to all the companies that fit into the category of “blended large market capitalization.”
What is a mutual fund?
In order to not bother you with too much detail, a mutual fund essentially works like an ETF; when you buy into a mutual fund, you are also buying into small fractions of the many different stocks, bonds, or commodities that the fund owns in its “basket.”
For example, let’s take a look at the mutual fund FXAIX (Fidelity 500 Index) which is similar to the SCHX ETF in composition but has $241 billion in assets. They look pretty similar in composition.
| Company | Portion of Fund |
| Microsoft Corp | 6.00% |
| Apple Inc | 5.78% |
| Amazon.com Inc | 4.50% |
| Facebook Inc A | 2.12% |
| Alphabet Inc A | 1.65% |
| Alphabet Inc Class C | 1.61% |
| Johnson & Johnson | 1.44% |
| Berkshire Hathaway Inc Class B | 1.35% |
| Visa Inc Class A | 1.27% |
| Procter & Gamble Co | 1.15% |
| JPMorgan Chase & Co | 1.11% |
| UnitedHealth Group Inc | 1.09% |
| The Home Depot Inc | 1.05% |
| Mastercard Inc A | 1.02% |
| Intel Corp | 0.99% |
What are the similarities and differences?
Similarities
- Both ETFs and mutual funds contain a bundle of different assets, often grouped by some sort of theme: industry segment, geography, asset class, etc.
- When you buy an ETF or a mutual fund you’re buying into a portion of the assets of that fund, and therefore, both help you diversify where your money is invested.
- Both require you to pay a maintenance fee every year to the company that manages the fund. The fund managers do all the work and research to determine what stocks to buy and sell, and how much, so you pay them a commission. Sometimes the fee can be low, 0.015% ($1.50 for every $1000 you invest), or high, 1.9% ($19 for every $1000 you invest) depending on how actively the fund is managed.
Differences
- Trading – ETFs can be traded like stocks; you can sell or buy them throughout the day, so the price of ETF shares fluctuate throughout the normal trading day just like a stock of a company would. However, mutual funds can only be purchased or sold at the end of the day based on the funds net asset value. Basically, you can’t trade a mutual fund throughout the day like a stock so the price doesn’t fluctuate throughout the day.
- Restrictions – Some mutual funds may require a minimum investment. Also, some funds may restrict the sale of the fund for a set time period after the purchase date, or they may impose a minimum holding period. In a sense, this causes mutual funds to be less “liquid”, or less easily convertible to cash. But, on the positive side, this may help you as an investor to stick to a long term investment strategy and be disciplined and hold on to investments for the long haul. I highly recommend reading the prospectus of an ETF or mutual fund before purchasing because it will outline the restrictions.
How can I use ETFs and mutual funds to diversify my investments?
Diversification
The great thing about both ETFs and mutual funds is their ability to diversify your portfolio and increase your exposure. Diversification is the equivalent of not putting all your eggs in one basket. Let’s say we wanted to invest in tech so we held just Facebook shares – this would be a high risk strategy in hopes of high returns. From July 2017 to July 2018 our Facebook stock would have soared from $116/share to $209/share to give us a whopping 80% return in one year. But by the end of 2018 Facebook dropped to around $120, and we just lost 41% of our investment.
If instead we had diversified into a large capitalization growth fund such as QQQ (this fund’s top holdings contain a basket of big tech such as Apple, Microsoft, Amazon, Google, NVidia, Tesla, Netflix, and Facebook), during that same time frame example you would have gained 45%, however, during the decline in the market, lost only 11%.
Exposure
Exposure is the second benefit you get from investing into EFTs and mutual funds. I never know what industry is going to thrive and grow in the future. During 2011-2020, big technology companies have seen tremendous growth, however, the winners of the next 20, 30, and 50 years are hard to predict. It could be artificial intelligence industries, it could be cloud computing companies, it could be gene editing startups, or real estate. Maybe China will see further rapid growth in the next couple of years. As they say, hindsight is 20/20.
ETFs and mutual funds lets our investments get exposure to many different industries, market segments, and regions while minimizing risk. For example, ARKG (Genomic Revolution) is an ETF that has a basket of companies working on gene editing and CRISPR. GBTC (Grayscale Bitcoin Trust) tracks the price of Bitcoin. MCHI (iShares China ETF) tracks the largest Chinese companies. NHMRX (Nuveen High Yield Municipal Bonds) is a mutual fund that exposes you to high yielding municipal bonds that can generate tax free passive income.
Conclusion
I think everyone should consider ETFs and mutual funds as great investing platforms. It can be tough to determine what stocks and companies to pick, not to mention time consuming. These funds can help you diversify your investments and get exposure to a broad set of categories while helping you control risk. Like with all investments, I highly recommend researching the funds before purchasing.