There is a lot of confusion between each of these funds: Index Fund vs Mutual Fund vs ETF (Exchange Traded Fund). What’s the difference between these? What makes one better than the other? Which person benefits from one more than the other?
To understand these differences we must dig into the details of each. They can be quite similar but their particular differences are what make them an entirely different fund.
In the following paragraphs, I’ll be explaining, in detail, what each of these funds is. From this, you will be able to pick up on the individual features that make them different from one another.
A mutual fund is a pool of money from multiple investors. This pool invests in different securities within the fund such as stocks, bonds, and short-term debt. These securities combined make up the portfolio in which the mutual fund is diversified.
Mutual funds have been around for longer than any of the other two funds. The first open-ended cap mutual fund was created on March 21st, 1924. It was created to facilitate the process of investing by allowing people to have their money actively managed by licensed professionals.
This means that the managers who are in charge of the mutual fund will be making trades with securities to reach their objective. In the short-term, this is effective. However, in the long term, this practice is not always successful.
Mutual fund managers struggle to “beat the market” on a consistent basis due to the unpredictable occurrences that take place within the market and the economy.
However, I stated earlier that mutual funds are actively managed.
Due to this fact, mutual funds tend to charge the highest management fees. These fees tend to be at a 1% – 2% average. This may not seem like a lot, but look at it this way:
If you invest $100,000 into a mutual fund, 2% of that is $2,000. That’s $2,000 that could’ve had gone into more investments to make you more money but, instead, they went to fees.
I hate to point it out because I have nothing against mutual fund managers, but I think people should be well aware of what they get into. If a mutual fund manager does not manage your money correctly and loses part of the value of your money by making poor investment decisions, your fee will remain the same and you will still be paying a portion of your money to that manager.
Nonetheless, this is not a usual occurrence. Fund managers tend to manage your money well and usually give back appreciated results. I simply think it’s important to point out the possibilities that can take place.
Mutual funds (for the most part) also have a minimum investment requirement. There are mutual funds available that don’t require a high minimum investment but they usually tend to require one. This minimum is usually between $500 and $5,000. Keep this in mind if you plan on making your first investment in mutual funds.
Benefits of Mutual Funds
Mutual funds have three major benefits:
- Diversification – this is the reduced risk you take by spreading your money among different securities
- Management by Professionals – Real people are constantly managing your money
- Convenience – You can own all the stocks within the mutual fund by making a purchase once, rather than once for each stock
Mutual funds have had tremendous success over the years which is why they’ve remained in existence. The money in mutual funds continues to provide quality returns over the years despite the higher maintenance fees.
If you choose mutual funds as your main investment tool, aside from the fees, make sure you look at its track record. I would personally choose a mutual fund that has at least a 10-year positive track record.
Yes, fees are involved, but if a mutual fund is beating the S&P 500 index for over a 10-year period, it might be a better option, despite the fees.
Index funds are not too far off from mutual funds. Essentially, they are mutual funds, but not all mutual funds are index funds. I’ll explain it.
Index funds are a basket of different securities in which your money will be equally invested. In contrast to ordinary mutual funds, index funds are passively managed. This is because index funds follow a specific index, instead of being actively traded. For example, an investment into the Vanguard 500 index fund (ticker symbol: VFIAX) will invest portions of your money into each of the funds held within VFIAX to follow that index.
An index is a representative sample of a group of securities. In this case, all the stocks held within VFIAX, which is the S&P 500, are what your money is being invested in. I provide more details on index funds in a separate article.
Due to the fact that they are passively managed, index funds are less expensive than ordinary mutual funds. Mutual funds usually charge a 1% – 2% average fee, while index funds will usually have a typical expense of about 0.2%, and usually less.
This makes a huge difference in your returns in comparison to mutual fund fees.
Benefits of Index Funds
Index funds have 4 major benefits:
- Automatic Investing – Feature where you can automatically set up your checking account to have a recurring monthly investment into your portfolio.
- Guaranteed appreciation of the index – As long as you stay invested, your money will follow the same pattern as the index which your fund follows. Historically, this trend has been upward in the long-run.
Since index funds are still a type of mutual fund, they also require minimum investments (for the most part). For example, the VFIAX fund requires a minimum of $3,000 to get started. But in the case that you don’t have that money available, each of these index funds is usually available as an ETF.
This takes me into the next section.
Exchange-Traded Funds (ETFs)
ETFs are very similar to index funds. This is because they are simply the smaller version of an index fund.
An ETF will still follow the index in which it is assigned, but it has different perks.
ETFs do not require a minimum investment, other than the price of the ETF. For example, the VFIAX index fund has an ETF version, this ETF version is VOO, which tracks the same S&P 500 index. VOO only requires you to buy the ETF at its given market price whereas VFIAX requires $3,000 to get started.
Another perk about ETFs is that you can buy and sell them at any time and as many times as you want when the market is opened. This is different from index funds which can only be bought and sold once a day. This makes it easy to simply trade ETFs as if they were stocks (which I do not recommend).
One downside about ETFs in comparison to index funds is that they don’t allow for automatic investment like index funds do. You have to manually buy each ETF on a regular basis if you are a dollar-cost-average investor. ETFs are also inexpensive when it comes to fees.
ETFs have the same benefits as index funds except that they can trade like stocks and they do not allow for automatic investment perks.
Despite all this, the fact that they can trade like stocks can be a downside because you might be tempted to sell your ETF when its index is going down. This is why you must keep in mind that you want to stay in the market for the long run. Don’t let your emotional senses make you sell when you see your money taking a down-dip. Stay in the market and stay strong, you’ve got time to recover.
What’s best for you?
Whatever is best for each person is relative. It all depends on your goals and how much you have to start.
If your goals are short-term then mutual funds might be the best for you (just don’t forget to factor the fees into your returns). If you have time and plan to stick in the market for the long-run, then index funds are your best bet. If you don’t have enough money available for the minimum deposits, but still plan to stay in the market for the long run, then ETFs might be best.
It’s all relative in the end. There are so many other things that can factor into your ultimate decision of which fund is right for you.
Just remember to stay strong, invest consistently, and hold your investment. You will be grateful that you did in the end.
If anyone has any specific questions please go ahead and leave them below, I will gladly respond!