There are two main types of tradable investment securities that individuals can own – Stocks and Bonds. Most investment portfolios include both of these in some proportion. Mutual Funds and ETFs provide a convenient way to buy a well-diversified mix of securities without having to buy and manage them individually.

Equity Securities (Stocks/Shares)

Equity securities represent ownership in a company. When you buy stocks, you become a shareholder and have a claim on the company’s assets and earnings (profit). Common shares (also known as common stock) are the most prevalent type of equity security, shareholders have voting rights and may receive dividends.

Equity securities are generally considered high risk investments, as their value can go to zero in the event of company failure or bankruptcy. They also have the potential for significant long term returns if the company performs well.

A stock’s value is based on a company’s ability to generate earnings, which can be distributed to shareholders as dividends, or reinvested within the company to drive future earnings growth and a higher stock price in future. Theoretically, the value of a company’s stock today should equal all expected future dividends discounted back to today’s dollars (the Net Present Value).

Debt Securities (Bonds/Fixed Income)

Debt securities represent loans made by investors to corporations, governments, or other entities. In return, the issuer promises to repay the principal amount along with interest. High quality bonds are therefore generally considered to be a low risk investment.

When you buy bonds, you are guaranteed to be paid back, unless the issuer defaults on the debt (e.g. company goes bankrupt). Higher risk companies or governments, or those in poor financial shape will pay higher interest rates to compensate investors for the increased chance of default. The safest (highest quality) bonds are those issued by financially stable governments, such as the US or Canada.

Mutual Funds

Mutual funds are pools of money, managed by a professional investor on behalf of those who put their money into the fund. There are thousands of mutual funds available in the Canadian market, typically managed by banks and other financial institutions. Mutual funds can own stocks, bonds or other types of securities, often with a particular strategy or set of rules that differentiates them from other funds. Funds can use an active (manually selected securities) or passive (tracking an index) investing approach.

The fund manager is compensated through a management fee, which is combined with trading costs and other administrative expenses to determine the Management Expense Ratio (MER) as a percentage of the total assets under management. Management costs are taken directly from the fund’s assets, i.e. not charged separately to investors. There may also be sales charges (commissions) when you buy and sell mutual funds.

Mutual funds are bought or sold at the end of each trading day, based on the net asset value (NAV) of the fund’s holdings. Open-ended fund units can be created or redeemed based on investor demand.

Exchange Traded Funds (ETFs)

Exchange traded funds are similar to mutual funds, except they are traded on a public stock exchange in real time rather than only at the end of the trading day.

ETFs also have management costs expressed as a Management Expense Ratio. They do not have sales charges for buying and selling, although some brokers may charge a trading commission and there will be a bid-ask spread (difference between buying vs selling price) due to the nature of exchange trading. On popular, high volume (liquid) ETFs, the cost of this spread is usually much less than the comparable commissions on mutual funds. Many discount brokers now allow ETFs to be bought and/or sold without trading commissions, keeping the overall transaction costs very low for investors.

ETF prices typically track very closely to the fund’s Net Asset Value (NAV) per share, through a mechanism of authorised participants creating or redeeming units based on investor demand.

So which type should I own?

There is a significant benefit to owning a broad basket of diversified securities compared to picking individual stocks and bonds yourself. Mutual funds and ETFs make this very easy to do, with ETFs typically offering lower overall costs and providing greater flexibility for those comfortable with the process of buying and selling securities on a public stock exchange.

Mutual funds can be more hands-off and suitable for investors who prefer to keep things as simple as possible, although there are now several low-cost “robo-advisors” available in Canada that automate the process of buying diversified ETFs for those that like a hands-off approach.

If you are looking for a low cost, all-in-one diversified fund, I recommend Vanguard or iShares Asset Allocation ETF products.