A mutual fund is a professionally managed company that collects money from many investors and invests it in securities such as stocks, bonds and short-term debt, equity or bond funds and money market funds.
Mutual funds are a good investment for investors looking to diversify their portfolio. Instead of betting everything on one company or sector, a mutual fund invests in different stocks to try to minimize portfolio risk.
The term is typically used in the US, Canada and India, while similar structures around the world include the SICAV in Europe and the open-ended investment firm in the UK.
What are the risks of investing in ETFs?
ETFs offer a low-cost diversification advantage. Despite these benefits, the risks associated with such investments should be noted. First, there are many types of ETFs available in the market, including international and exotic ones. So selecting the right ETF to meet your needs is key to avoiding additional risks such as political risk and liquidity risk that can be associated with these ETFs. ETFs can also be exposed to counterparty and currency risk depending on their underlying holdings.
ETFs can have different structures depending on what they invest in and how they distribute portfolio capital gains. This can affect the tax responsibility for the investor. For example, ETFs that use exchanges in kind do not distribute capital gains to end investors, while ETFs involving derivatives or commodities can have complex structures and tax implications. Unless an investor is aware of these things, they may be caught off guard.
ETFs are exposed to market risk like equities and other mutual funds despite their diversification advantages. The larger the index an ETF tracks, the lower its market risk will be, but it cannot be completely eliminated. ETFs face a tracking error, i.e. their return deviates from the yield of the underlying index because an ETF incurs certain expenses that the index does not face.