What’s the difference between index funds mutual funds versus ETFs. Each of these are different but similar investment vehicles with their own pros and cons. We hear these terms get thrown around a lot, and actually a lot of people mix them up. It can be confusing.
So if you want to learn the difference between index funds mutual funds and ETFs, and which option might make the most sense for you. So, this blog post is about you.
Mutual funds came way before index funds and ETFs and the earliest-known mutual fund was supposedly invented way back in the1800s. They were created as a way for a bunch of people to pool their money and make investments together.
Benefits of Mutual Funds
i) Convenience: By investing in a mutual fund you get to own a bunch of different stocks all in one easy package. A Mutual fund could have hundreds of different stocks in it But you only have to make one Purchase. In a world without mutual funds, if you wanted to have say a hundred different stocks in your portfolio. You’d have to make 100 separate purchases which means you pay trading commission a hundred times and you’d waste a lot of time sitting in front of the computer.
ii) Get instant ownership: By investing via a mutual fund you get instant ownership in all the stocks the mutual fund already owns. And owning a lot of stocks all at once gives you diversification, which is the second major benefit of mutual funds. Diversification is a strategy that reduces your investing risk by spreading out your eggs. Instead of having all your money in one stock which is the equivalent of putting all your eggs in one basket you
Spread out your money of across many different stocks. That way if one of the stocks in the mutual fund totally crashes you’ll still be fine, because each stock is only a small portion of your overall portfolio.
Mutual funds typically consist of around 90 stocks at a minimum, so they provide a lot of diversification that would be hard to replicate on your own.
ii) Managed by investment professionals: Rather than try to find stocks on your own, you have some super smart guy who supposedly knows what he’s doing pick the stocks for you. So mutual funds offer convenience, diversification, and access to professional money managers.
But that doesn’t mean mutual funds are 100 percent amazing. Convenience and diversification are definitely good benefits. But the problem with having professional fund managers is that they charge a lot of fees. When some really smart well-educated professional is picking the stocks for your mutual fund, that’s called “active management“.
In return for managing your money actively managed mutual funds charge an annual fee of one to two percent of your account balance every year. So at 2% if you invested $10,000 in a mutual fund, $200 of that goes straight into the fund managers pocket.
And even if the manager makes poor investment decisions and your account balance actually goes down next year, you still get charged 2%. So you could literally end up with less money than you started with but the fund manager would still get paid millions of dollars for their services.
And even if you find a fund manager who’s done really well for a couple of years. Their performance usually doesn’t last over the long run, and the cost of fees can really add up.
Over the years fees will reduce your nest egg by hundreds of thousands of dollars. So the vast majority of mutual funds are totally not worth the high fees.
One day a guy named Jack Bogle got so sick of mutual funds ripping people off that he invented a whole new category of mutual funds called Index funds. And index fund totally revolutionized the investing landscape.
Unlike traditional mutual funds, Index funds are passively managed. This means that rather than paying an expensive fund manager to do active management, the fund follows a fixed formula that totally eliminates the need for someone to make buying and selling decisions.
The formula that it follows is based on an index, and that’s where the term index fund comes from. An index is a representative sample of the stock market and indexes were created as a tool to quickly measure stock market performance.
Rather than looking up thousands of stocks individually, an Index is just one simple thing you can look up to just see how the stock market did that day. If you’re not sure what a stock market index is, then make sure to check out this video right here for an in-depth explanation.
So Jack Bogle created the first index fund in the 1970s, and it mirrored the the S&P 500 index which is one of the most widely followed indexes in the world. Since the fund simply buys whatever stocks are in the S&P 500 index, the fees are much much much lower because you’re not paying for expensive fund managers to make these decisions for you.
The Vanguard S&P 500 index fund charges an annual fee of .04%.
So index funds are a type of mutual fund. All index funds are mutual funds, but not all mutual funds are index funds. An index fund will clearly state that it tracks an index, and it will specify which index it tracks.
Mutual funds that are index funds and mutual funds that are actively managed and so are not index funds.
ETF (Exchange-traded funds)
ETFs also known as exchange-traded funds. ETFs were introduced about 15 years after the first index fund, and they’re very similar to index funds except for one major difference: with index funds you can only buy and sell shares once a day.
But with ETFs you can buy and sell your shares whenever the stock market is open even though an ETF is not really a stock you can buy and sell ETFs as if they were a stock. A lot of times you’ll hear the terms ETFs and index funds used interchangeably but they’re not the same thing.
If you wanted to invest in the S&P 500. You could either go with an S&P 500 Index fund like the Vanguard, or you can go with an ETF like the SPDR S&P 500 ETF.
The question you have to ask yourself is do I need the 24/7 tradeability that in ETF offers, or am I just good with an index fund?
In my experience being able to trade ETFs really doesn’t help you achieve long term investing success. Because the fact that it trades like a stock and you can watch it go up and down on a stock chart. It really only encourages impulsive buying and selling.
Human nature has a tendency towards gambling like behavior, which is obviously the opposite of smart investing. So I personally think ETFs do more harm than good.
So if you’re not sure whether you should go with ETFs vs index funds then I would recommend just choosing index funds. They’re essentially the same thing, but you won’t have the added temptation to gamble with your money.
Most people will only have to buy once, hold and then sell when they retire. So you really don’t need the 24/7 tradeability of an ETF.
Another reason you should prefer index funds is that index funds offer automatic reinvestment. This makes it really easy for you to save and invest without even lifting a finger. Index funds allow you to set up a recurring monthly deposit from your checking account and they’ll automatically buy more shares for you every month.
The best part is that there’s no additional charge for doing this. This is a free automatic reinvestment feature and it makes it a no-brainer for you to automate good investing habits. ETFs do not offer this feature if you wanted to contribute more to your investments every month. You’d have to buy more shares of the ETF every month, which means more work for you.
So I hope you have a better understanding now of mutual funds, index funds, ETFs and what similarities and differences they have. Mutual funds came first and they offered the benefit of pooled investing, then index funds came along as a special type of mutual fund with much lower fees and a type of management called Passive management. Then finally the ETF came on the scene which trades like a stock and offers everything that index funds offer except automatic reinvestment.
I hope you liked our blog post and it was helpful for you to understand the difference between Index Funds, ETFs and Mutual Funds. For more Financial posts like this visit www.dollarviral.com.
Thankyou for reading. Have a good day.