Mutual Funds for Diversification

Diversifying by combining direct ownership of stock and other methods is a very popular choice. The mutual fund has been a widely popular investment vehicle for many decades. A fund is an organization that combines the capital of thousands of individuals to create a single diversified portfolio. Funds are organized by investment objective (conservative, aggressive), type of income (growth, income), or a balance of these criteria -- an income fund, for example, focused on bonds and, to a degree, on stocks paying higher-than-average dividends. A balanced fund buys positions in both equity and debt.

A variety of the traditional mutual fund is the exchange-traded fund (ETF). This is a mutual fund that identifies a 'basket of stocks' in advance and does not change that mix unless one of its components changes.

The traditional mutual fund can be bought and sold only by communicating directly with the fund's management. Value of a share of a mutual fund is determined at the end of the trading day only. In comparison, an ETF can be bought or sold on the public exchanges, and value changes during the trading day just like stock.

One great advantage to the ETF beyond its high liquidity is that it identifies its components in advance, meaning the management of the fund is virtually automatic. Mutual funds charge for managing a portfolio and once you buy shares you have little to say about the buy and sell decisions management makes. In an ETF, you know in advance what is in the fund. This is an advantage because it gives you automatic diversification; it is also a disadvantage because the return on an ETF is going to be the average of all its components. For example, if an ETF holds 10 stocks in one sector, of which three outperformed the others, the overall return is going to be equal to the average of all 10, not of the three outperformers.

ETFs exist for a variety of defined groups, including:

• Specific sectors or industries
• Stocks of specific countries or regions
• Shorts (ETFs that sell components instead of buying)
• Emerging markets
• Debt instruments, including fixed-income ETFs
• Currencies
• Real estate
• Commodities

Every month, new ETFs are added to the growing list, and new categories are also added. The ETF market is an excellent way to diversify as long as you think the entire basket of stocks (or bonds) is worth holding. Remember, though, that an ETF will only earn the average return of all its components.