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Tae Kim

Tae Kim

Index Funds vs. Mutual Funds vs. ETFs

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So you are out to dinner with your friends and you want to make a lasting impression.

Do you know what would really impress them?

Being able to explain the difference between a Mutual Fund, an Index Fund and an ETF.

Mutual Fund

It’s actually the oldest of the three.  It first started out in Europe and made its way to the United States in the 1890s.

It’s technical definition is that it is a professionally managed investment fund that pools money from many investors to purchase securities.

In simple terms, it was created as a way for a group of rich people to pool their money and purchase investments together.

The concept is quite powerful because it provides individual investors several benefits.

Diversification

Diversification in investing is very important because by diversifying your investments across many companies and industries, you are reducing your investing risk.

Imagine if you had all your money in one company. If that company did well, yes, you can make a lot of money. However, if that one company crashed – then you’ve just lost all the money you had in the market.

However, if you had purchased a mutual fund that has several companies within it, you are diversified and your risk drops. Even if one crashed, that is just one of the many companies you own within that mutual fund.

As the saying goes, you aren’t putting all your eggs in one basket.

In order to replicate this diversification on your own, you would need to purchase multiple single stocks and manage them all on your own.

And this highlights the next benefit which is convenience.

If you were to try replicating the many stocks in a single mutual fund, you would need to spend hours buying individual stocks on your own.

Imagine that a mutual fund has 100 stocks within it.

Instead of hitting buy on that one single mutual fund, can you imagine purchasing 100 single stocks on your own one my one? And what if you want to update your portfolio with different stocks. You’d have to manually sell and buy new ones.

The introduction of mutual funds into the market was revolutionary because it gave people the convenience of diversification in an instant.

However, the one key difference between a mutual fund and the other vehicles we will discuss here in a bit – index fund and ETFs, is that they are managed by investment professionals.

Some would argue that this is a benefit of owning mutual funds.

Let the expert take care of managing my money. I have no idea what I’m doing.

That might be good for some people, but I would think twice before handing over the control of my investment to someone else.

Professional fund managers’ primary goal with the funds they manage is to beat the index – we’ll talk more about index funds in the next section, but simply, think of a fund that includes all the publicly traded companies in the market.

According to Goldman Sach data, the average 10-year stock market return is 9.2%.

The fund manager is trying to beat that average. Trying to get it’s investors more than 9.2% in return.

However, this comes at a cost. For managing your money and trying to beat the index, they charge an annual fee, also known as expense ratio of 1 to 2% of your account balance.

Imagine you had invested $100,000 into an actively managed mutual fund and the fund manager charges 2% for his or her service.

You are paying $2,000 annually.

And this gets charged regardless of how well the fund is doing.

Compare that to my favorite index fund, VTSAX which only charges 0.04%. 50x less.

Unless your fund manager is ridiculously amazing, and this is pretty rare – you can find out more about it in my article why you don’t need a Financial Advisor here.

You could end up with less money than you started out with.

So, for most people, I would not recommend mutual funds because they aren’t worth the high fees.

Index Fund

Moving onto Index Fund.

My favorite type of investment.

The king of all index fund investments are created and managed by a company called Vanguard.

It was founded by a gentleman named Jack Bogle.

He wanted to provide the regular investor the ability to tap into the amazing growth of the stock market, without the need to go through an investment manager and the high fees.

Actually when you step back, there are a lot of similarities between mutual funds and index funds.

They both provide diversification through the ability to purchase multiple companies in a single fund. And they also provide the convenience that comes with being able to buy a group of stocks with just a single click.

However, here is the key difference. While mutual funds are actively managed by fund managers, index funds are passively managed.

Unlike a human selecting what he or she thinks is the best company to add to the mutual fund, an index fund has a formula that just tracks an index.

You most likely have heard of them – Standard & Poor’s 500 Index, also known as S&P 500. Dow Jones Industrial Average (DJIA), or simply Dow Jones.

The S&P 500 is tracking the 500 largest publicly traded companies.

The Dow Jones tracks 30 large-cap companies.

And what the index fund does is literally just mirroring the index – whether it is the S&P 500 or the Dow Jones.

It simply buys whatever stocks are in the index it is trying to mirror.

No person is making the buy or sell decisions. A formula takes care of all that because it isn’t trying to beat the market. It is just following the market.

And this is where the best part of owning an index fund comes in.

Because there are no fund managers and analysts the fund needs to pay for, it can keep its annual expense quite low.

My favorite index, the VTSAX from Vanguard only charges 0.04% annually.

Again, this is 50x less than what an actively managed mutual fund would charge.

For a busy individual like yourself trying to manage a full household, there is no need to pay extra for a mutual fund that most likely won’t do any better than an index fund.

I’d recommend an index fund over a mutual fund any day.

ETFs

Now, let’s move onto ETFs.

ETFs are the lesser known younger brother of the two funds that we just discussed. But it sounds much cooler, so knowing this will surely impress your dinner mates.

ETFs, also known as Exchange Traded Funds.

They are similar to index funds in the sense that they too track an index.

And like an index fund, ETFs funds are also passively managed. No fund manager in between to meddle in your business.

However, the key difference between the two, is that, while an index fund trades once a day, when the market closes. ETFs trade throughout the day.

As its name implies, Exchange Traded Funds, ETFs trade on an exchange like individual stocks, while mutual funds and index funds do not.

This in essence gives you more flexibility.

It’s easier to get in and out of the market than an index fund since you don’t have to wait until the market closes for your trade to go through.

However, you have to consider what additional value this flexibility is providing. And is it more than what you can get with just purchasing a simple index fund?

If you’ve read any of my other content, you know I advocate for long-term investing. I mean, my site is called Financial Tortoise for a reason.

To me the ability to trade throughout the day doesn’t add much value. We should be investing for the long run, I mean 5 to 10 year horizons, not a day.

If you had to choose between an ETF and an Index Fund, I would say the Index Fund wins again.

Conclusion

There you go guys. I hope this helps you to better understand the difference between a mutual fund, index and ETFs.

Now, go and dazzle your dinner mates with your amazing knowledge about the market.

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