Index Fund vs Mutual Fund vs ETF – Know the Differences

Index-Fund-vs-Mutual-Fund-vs-ETF
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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.

Mutual Funds

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.

Also…

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

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:

  • Diversification
  • Convenience
  • 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!

 


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18 Comments

  1. Very informative post about the differences between the Index Fund, Mutual Fund, and EFT.  I have to say sometimes the terminology can kind of blur together or seem the ‘same’.  You broke down the information so well!  Very simple to understand.  

    I believe Index Fund’s are a great way to diversify.  I really like how you are equally invested into different securities which is a great way to hedge your portfolio.  One of my family members does have Vanguard and has done very well over the years with his investment.  I never realized it was an index fund until coming across your site.  I definitely will be learning more about index funds myself.

    Thank you for sharing such valuable information with your readers!

    1. Absolutely! I’m glad this could help! Your relative must be doing quite well with his investments! Maybe COVID might’ve given a scare (for basically anyone who’s invested in the market Haha) but at the moment things seem to be picking back up! Thank you for your feedback! 🙂

  2. Md. Asraful Islam

    Thank you so much for sharing with us a beautiful and informative article. The main content of this article is about Index Fund vs Mutual Fund vs ETF. It is truly remarkable that you have presented this topic so well in your article. I have learned a lot by reading your article and gained a lot of knowledge about it. Of the points mentioned in your article, I like Mutual funds benefits. I always recommend Mutual Funds as it will make your investment profitable very fast.

    Finally, I enjoyed reading your article and enjoyed it so I’d like to share your article in my Facebook group if you give me permission.

    1. Sure thing! Go ahead and share with who ever you want. Mutual funds are a good option! None of these are really bad options but it’s particular to each individual. Thank you 🙂

  3. Thanks for sharing this, it will really help me on my investment path all the way. You kinda just opened up a way to make money differently and more safely with my investments than what I’m used to with this post, so thank you haha. The ETF and the index fund still look somewhat the same to me through.

    1. Of course! That’s because they are very, very similar. Think of ETFs as an individual stock that can be bought and sold just like stock… except that this stock follows an entire index. Index funds can’t be bought & sold like stocks whereas ETFs can. Also don’t forget that because ETFs can be bought and sold like stock, they also don’t have minimum requirements to invest as some index funds do. Some index funds require about a $3,000 minimum to get started. Index funds also offer automatic reinvestment plans, unlike ETFs where everything is manual. Hope this helped! If any other questions arise, let me know.

  4. Index funds are passive in management – meaning they are not actively trading or adding investments. … On the other hand, mutual funds are active in their management style – meaning that fund managers or analysts are actively picking fund holdings (like individual stocks, bonds or other securities.The biggest difference between ETFs and index funds is that ETFs can be traded throughout the day like stocks, whereas index funds can be bought and sold only for the price set at the end of the trading day

  5. Thank you for sharing this here. Well! I had no idea about this index find and everything before reading this post here and I can say that I have quite a bit more clarity here after reading here. I actually love the idea of getting into this. I am currently invested in mutual funds and definitely they are coming up good. 

    1. That’s excellent! I’m glad I could open up an array of options for you with this post 🙂

  6. Awesome and thank you for sharing this information with us. You have opened my eyes to look for ways to invest money differently and more safely than what I’m used do. Thank you very much. What investment companies do you recommend one to use? I use TD Investment and is thinking of moving to IVARI.

    1. I’m fairly familiar with TD and I think they’re very good. I’ll be honest, I’m not too familiar with IVARI to give you a well-educated opinion on it. But I’ll be sure to do my research on them in the future.

      I’ll be posting some articles of investment brokers that I think would be useful to people and ones that I personally think it would be a better idea to stay away from. But like I said, I’m not too familiar with IVARI just yet so I can’t give you on an educated opinion on whether making that move is a good or a bad idea. Regardless though, TD isn’t bad and I’m more familiar with them to be able to confidently tell you that!

  7. When it comes to Mutual Funds, I think it is good that we can shop for the sector that the fund is investing in so that at least I feel I am involved in the industry sector that I like. When it comes to ETF or Index Funds, I think it is just following the market movements of that index so once invested, just don’t look back as it is for the long term. Actually, even for Mutual Funds, I think we should be looking at an investment horizon of medium to long term too? In the end, it is good to invest in at least 2 of these to diversify. And we should also learn about value investing to really invest in companies that we can associate with. 

    1. Absolutely! I mentioned in the article that mutual funds tend to do better on a shorter run… BUT they are still long-term investments. When choosing a mutual fund, you must look at the long-term prospect of the fund. If they have a great track record over the past 10+ years it is definitely something to look into! Even though not all fund managers may be perfect, we can look at mutual fund track records to ensure that what we are putting our money into is safe and promises a sound return, this can certainly happen with mutual funds. And yes! Diversify! Especially if you don’t want to put all your efforts into choosing individual stocks. As investors, we need to do out due diligence to find out more about what we are investing in, what are the long-term prospects, what’s the track record, etc. Value investing is usually aimed at individual stocks, but it can definitely be applied to funds as well. Value investing is the best form of long-term investing. Thank you so much for your feedback!

  8. Hello Misael, thanks for sharing this wonderful article and I have to admit that I really didn’t know anything about these various types of funds except the ETF and this is one article that can give you all the knowledge you’ll need and it means a lot to all of us. This would go along way to making we all understand better 

    1. I’m glad to hear that this was helpful! Really appreciate the feedback 🙂

  9. Invested in mutual funds in 2004, but when stocks started crashing 2006 and beyound, I had to pull out my funds. I was afraid I was going to loss funds. Now stability have returned. I think it is time I begin to look at investing. The way u explained mutual funds and indexed funds really gives me a balance. Now I know dt not all mutual fund are index. 

    1. Glad this was helpful. And I’m glad to hear that you’re getting back into investing! It can be daunting to get into with all the volatility involved, but if you make a plan and stay the course, you shouldn’t be disappointed in the long run! Thank you for your feedback 🙂

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