As any gardener knows, you’d be ill advised to plant only a single seed in the hope that this will be the one that grows the prize pumpkin. You’d be better off planting a whole pumpkin field, as you’d be very likely to have a good harvest even if you have some less successful plants as well.

Funds are a little like this field: They pool investors’ money to buy many different individual shares, bonds or other assets (in our metaphor, the pumpkin plants). Some assets will do exceptionally well, others less so. But as the owner of a basket of many shares or bonds, those weak performers won’t impact you too much, and you have a better chance of owning those assets that really drive returns.

Our research confirms this. We’ve found that investors increase their chance of earning a better return and avoiding losses if they invest in many different shares at the same time. In fact, the greater the range of different shares held by investors, the better their odds of ultimate investment success¹.

But what differentiates the different types of funds that are available, and how do you choose one?

Shares or bonds

One of the main characteristics of a fund is the asset class it invests in. Bonds typically offer more stability for your portfolio at the expense of return opportunities while shares can fluctuate more but have historically offered higher returns in the long run. There are also multi-asset funds, which typically allocate a certain percentage of the fund portfolio to each asset class. The higher the proportion of bonds in the fund, the more defensive the strategy. A higher proportion of shares will introduce greater risk and greater return opportunities.

Markets and regions

Each fund defines a certain strategy regarding the market or region it focuses on. Some funds take a global approach, which typically offers good diversification across markets. Other funds focus on a single country, like the UK, or a continent. In addition, funds may focus on either large or small companies, or – in the case of bonds – on businesses or governments with a specific level of creditworthiness. Assets from emerging markets typically offer greater risks and rewards than those from industrialised countries, and bonds from investment-grade issuers (issuers with good creditworthiness) offer more stability than high-yield bonds (those from issuers with lower creditworthiness).

Active or index

Another choice to make is between active and index funds. Active investment funds typically have a manager who tries to beat average market returns by choosing investments they consider especially promising. Index funds on the other hand attempt to match average market returns by replicating an index like the S&P 500, which contains 500 large American companies.

Index funds typically come with lower fees since the research that goes into active management and stock-picking often comes at considerable cost. A fund’s cost is an important factor to consider. The higher the cost, the more returns a manager will need to generate before they are putting any money in your pocket. However, our research shows that very few active managers are able to consistently outperform their market after costs, and it’s difficult to identify them in advance².

That’s not to say that index funds are always the better choice. If you’re willing to take on this additional “manager risk” (the risk that the manager you pick won’t consistently outperform after fees), then active funds offer the chance to achieve above-average returns. (Read more about active and index fund investing.)

Mutual fund or ETF

When you’re comparing different funds, some may have the acronym “ETF” in their name, like the Vanguard FTSE All-World UCITS ETF, while others are simply termed “funds” or “mutual funds,” like the Vanguard LifeStrategy 60% Equity Fund.

ETF stands for “exchange-traded fund.” As the name states, ETF units are traded like individual shares on exchanges, with prices moving constantly during trading hours. For mutual funds, fund providers determine a price once a day at which units are traded. If you are a long-term investor, this will only make a minimal difference to your investment outcomes.

So which type of fund is better for you? Availability can occasionally limit your choice. Some funds are only available as an ETF, others only as a mutual fund. The majority of ETFs follow an indexing strategy, but there are also actively managed ETFs as well as mutual funds that track an index. At Vanguard, we offer both active and index exposure through ETFs and mutual funds. 

Start by figuring out which fund you’d like to invest in. There’s nothing wrong with combining ETFs and mutual funds in one portfolio. (Read more about ETFs and mutual funds.)

Past performance

Past performance is an interesting aspect to consider when choosing a fund, but it’s important that you don’t read too much into it. Historical performance charts can give you an indication of how stable or volatile a fund is. Comparing past returns to the returns of a benchmark index (an index that has a similar or the same focus as the fund) can give you an indication of how good of a job the fund manager is doing. But there is no guarantee that past trends and successes will continue into the future. When you do look at past performance, always take the long view: The average returns of the past 5 or 10 years will give you a more reliable picture than a single year’s returns.

Advantages of funds

Whether index or active, ETF or mutual fund, equity or bond fund – funds are a great tool for building wealth over time. They can lower the overall risk of your investments by spreading your money over a wide range of assets. They’re flexible as they allow you invest or withdraw money daily in small or large amounts. And you can choose from a wide range of strategies to suit your goals and appetite for risk.

In the next part of our four-part series, read about how to monitor your investments over time to make sure you stay on track.

¹ © [2019] Pageant Media. Republished with permission of PMR of Investing. “How to Increase the Odds of Owning the Few Stocks that Drive Returns”, Chris Tidmore, Francis M. Kinniry Jr., Giulio Renzi-Ricci, and Edoardo Cilla, volume, volume 21, number 1]. For more information, please visit www.PM-Research.com. All rights reserved.

² Rowley, James J. Jr., David Walker and Carol Zhu (2019) “The Case for Low-Cost Index-Fund Investing”