What is the difference between index funds, mutual funds, and ETFs?
Each of these is a different but similar investment vehicle with pros and cons.
So, I know it can be not very clear.
I have a degree in finance. But I didn’t even learn this stuff in school.
When I invested in ETFs for the first time I learned later on that ETFs didn’t have this one essential feature that I wanted in my investment portfolio,
So, I had to switch to index funds, which was a hassle. I want to save you this trouble! In this Story,
I want to share everything I learned with you so you can be more informed before investing in your research.
So, if you want to learn the difference between index funds, mutual funds, and ETFs, Which option might make the most sense for you?
Then, keep on reading.
Before we get started, go ahead and hit that follow button!
My Story is about money and investing for beginners, and it will help you learn.
Mutual Fund
I will start with mutual funds because they’ve been around the longest.
Mutual funds came way before index funds and ETFs, and the earliest-known mutual fund was supposedly invented in the 1800s.
They created a way for a bunch of people to pool their money and make investments together.
Mutual funds offer three significant benefits:
The First is convenience.
Investing in a mutual fund allows you to own many different stocks in one easy package.
A Mutual fund could have hundreds of different stocks. But you only have to make one Purchase.
In a world where mutual funds do not exist, an individual looking to diversify their portfolio would need to invest in a hundred different stocks.
You’d have to make 100 separate purchases.
That means you pay trading commission a hundred times, and you’d waste a lot of time sitting in front of the computer, clicking the Buy button a hundred times.
So inefficient, right?
But 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 a significant benefit of mutual funds.
Diversification is a strategy that reduces your investing risk by spreading out your eggs this is a second benefit of mutual funds.
Instead of having all your money in one stock. That is the equivalent of putting all your eggs in one basket: you Spread your money across many different stocks.
That way, if one of the stocks in the mutual fund crashes,
you’ll still be okay because each stock is only a tiny portion of your overall portfolio. Mutual funds typically consist of around 90 stocks at a minimum,
They provide a lot of diversification that would be hard to replicate.
The third benefit of mutual funds is that investment professionals manage them.
So rather than try to find stocks on your own, you have some super intelligent guy who Supposedly knows what he’s doing to 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 good benefits,
But the problem with having professional fund managers is that they charge a lot of fees. When some intelligent, well-educated
A professional is picking the stocks for your mutual fund, called “active management.” In return for managing your money,
Actively managed mutual funds charge an annual fee of (1 to 2) percent of your account balance yearly.
So at 2%, if you invested.
Fees
If you invested $10,000 in a mutual fund, $200 of that goes straight into the fund manager’s pocket.
And even if the manager makes poor investment decisions and your account balance goes Down next year, you still get charged 2%.
So you could end up with less money than you started, But the fund manager would still be paid millions for their services.
And even if you find a fund manager who’s done well for a couple of years, Their performance usually only lasts for a short time, and the cost of fees can add up.
Over the years, fees will reduce your nest egg by hundreds of thousands of dollars.
So, most mutual funds are not worthless because of the high fees.
The Index Fund
The index fund revolutionized the investing landscape. Unlike traditional mutual funds,
Index funds are passively managed.
That means that rather than paying an expensive fund manager to do active management,
The fund follows a fixed formula that eliminates the need for someone to make buying and selling decisions.
The formula 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 index funds are created to measure stock market performance quickly rather than looking up thousands of stocks individually.
An Index is just a straightforward thing. You can see how the stock market works that day.
Jack Bogle created the first index fund in the 1970s, which tracked the S&P 500 index — one of the most widely followed indexes worldwide.
Since the fund 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 0.04% percent. it’s Peanuts!
So, index funds are a type of mutual fund?
All index funds are mutual funds, but not all the index funds.
ETFs
They are also known as exchange-traded funds.
ETFs are introduced about 15 years after the first index fund, and they’re very similar to index funds,
Except for one significant 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 opens.
Even though an ETF is not 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 funds like the Vanguard one that I mentioned earlier, or you can go with an SPDR S&P 500 ETF.
You have to ask yourself whether you need the 24/7 traceability that ETF offers, or am I just good with an index fund?
Being able to trade ETFs 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 only encourages impulsive buying and selling.
ETFs vs Index Funds
Human nature tends to engage in gambling-like behavior, which is the opposite of smart investing.
So, I think ETFs do more harm than good, and you know,
why even deal with the added temptation?
So, if you’re unsure whether you should go with ETFs vs index funds, choose 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 don’t need the 24/7 tradeability of an ETF.
Another reason why I like index funds and this is a good reason actually and the reason why I switched over from
ETF to index funds is Because index funds offer automatic
Reinvestment.
That makes it 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.
That free automatic reinvestment feature makes it a no-brainer for you to automate good investing habits.
ETFs do not offer this feature if you want 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 of course.
It means you must pay trading commissions every time, and who wants to do that?
I hope you better understand mutual funds, index funds, and ETFs and their similarities and differences.
Mutual funds came first, and they offered the benefit of pooling.
Investing, then index funds, came along as a particular type of mutual fund with much lower fees and a kind of management called.
Passive management, and then finally, the ETF came on the scene, which trades like a stock and offers everything that index funds provide except automatic reinvestment for more beginner-friendly investment,
If you have any questions at all about what I write about in this Story,
Let me know in the comments, and I’ll reply.
