Funds: what you actually own when you buy one

Buying a fund is like buying a slice of a whole shelf at the market instead of one apple. You get a little of everything on that shelf. Whether the shelf holds five hundred big companies, a few dozen bonds, or something stranger is the real question, and the fund's name only sometimes tells you.

What a fund is

A fund pools money from many people and buys a collection of investments for all of them. You own shares of the fund, and the fund's value follows the value of what it holds. An index fund copies a published list, like the 500 biggest US companies, and only changes when the list changes. An actively managed fund pays people to pick and choose in the hope of doing better, and charges more for the effort.

Mutual funds and ETFs

A mutual fund is bought and sold once a day, at a price worked out after the market closes. You say how many dollars, and it fills at that evening's price. An ETF, an exchange traded fund, trades all day like a stock. You buy shares at whatever price the market shows that moment, which may be a hair above or below what the holdings are worth.

What it costs

The expense ratio is the yearly fee, a percent of what you have invested, taken out of the fund's returns continuously. You never see a bill. A fund charging 0.03 percent takes $3 a year per $10,000 you have in it. One charging 1 percent takes $100. Over thirty years the second fund has to beat the first by a full percentage point every single year just to tie, and the fee calculator shows what that means in ending dollars. Some mutual funds also charge a sales load, a percent taken when you buy or sell, and some brokers charge to trade certain funds. It is all in the prospectus, which the paperwork reader on this site will read for you.

Where the tidy version goes wrong

"An index fund is safe" mixes up spread out with safe. A fund holding five hundred stocks still drops when stocks drop. It removes the risk of one company failing, not the risk of the whole market falling. And "ETFs are better than mutual funds" is only sometimes true, mostly in taxable accounts for people who want to trade during the day. A cheap index mutual fund inside a 401(k) is often exactly the right tool.

Questions worth asking yourself

What does the fund actually hold, and does its name match? What is the yearly fee, and is there a load? Is it an index fund or a managed one, and if managed, how has it done against its benchmark after fees over many years? Is it in a taxable account or a retirement account? And, for an ETF, how much of it trades each day?