Best Passive Investment (Index Funds vs ETFs vs Mutual Funds)
What sets index funds, mutual funds, and ETFs apart from each other?
While these investment vehicles share similarities, they also have distinct characteristics and advantages and disadvantages.
It's common for people to confuse these terms, even though I have a finance degree, I didn't learn about these differences in school.
When I initially invested in ETFs, I discovered later on that they lacked a crucial feature I wanted in my investment portfolio.
This led me to switch to index funds, which was quite inconvenient. I want to spare you from going through the same trouble.
So in this article, I'll share everything I've learned so that you can make more informed investment decisions.
If you're interested in understanding the distinctions between index funds, mutual funds, and ETFs, as well as determining which option is most suitable for you, then keep reading.
But before we dive in, please subscribe to my channel. I focus on personal finance and investing topics for beginners, and I'm confident it will provide you with valuable knowledge.
Now, let's get started.
Mutual Funds
Let's begin with mutual funds, which have the longest history among these investment options.
Mutual funds have been around since the 1800s and were initially created as a means for individuals to pool their money and invest collectively.
There are three key advantages of mutual funds.
#1: Convenience
By investing in a mutual fund, you gain ownership of a diversified portfolio of various stocks in a single package.
Without mutual funds, acquiring a hundred different stocks would require making a hundred separate purchases, incurring trading commissions and wasting significant time.
However, with a mutual fund, you instantly own shares in all the stocks held by the fund.
This leads us to the second major benefit:
#2: Diversification
Diversification is a risk reduction strategy that involves spreading your investments across different assets.
Instead of putting all your money into one stock, which is like putting all your eggs in one basket, you distribute your funds across numerous stocks.
This way, if one stock in the mutual fund performs poorly, your overall portfolio remains relatively unaffected since each stock represents only a small portion of your investment.
Mutual funds typically consist of a minimum of around 90 stocks, providing a level of diversification that would be challenging to achieve independently.
The 3rd advantage of mutual funds is:
#3: Managed By Investment Professionals
Instead of you having to select individual stocks, you rely on the expertise of a knowledgeable fund manager who is responsible for choosing the stocks within the fund.
This aspect provides the benefit of professional management.
So, in summary, mutual funds offer convenience, diversification, and access to skilled money managers.
Fees Charged (Mutual Funds)
However, it's important to note that mutual funds do come with some drawbacks.
While convenience and diversification are certainly beneficial, one issue is the fees associated with professional fund management.
When you have experienced and well-educated professionals actively selecting stocks for the mutual fund, it falls under the category of "active management."
In exchange for this active management, mutual funds charge an annual fee, typically ranging from one to two percent of your account balance each year.
With a mutual fund charging a 2% fee, if you were to invest $10,000, $200 of that would go directly into the fund manager's pocket.
What's concerning is that even if the fund manager makes poor investment decisions and your account balance actually decreases the following year, you still get charged the 2% fee.
This means you could end up with less money than you initially invested, while the fund manager still receives millions of dollars for their services.
Furthermore, even if you happen to find a fund manager who has achieved remarkable performance for a couple of years, their success tends to be short-lived, and the cumulative effect of fees can be significant.
Over time, these fees can diminish your savings by hundreds of thousands of dollars.
Therefore, the majority of mutual funds are generally not worth the high fees they charge.
Index Funds
However, the introduction of index funds brought about a game-changing solution.
It all began when a man named Jack Bogle, who was fed up with mutual funds taking advantage of investors, created a new type of mutual fund called index funds.
Index funds brought about a significant revolution in the world of investing.
Unlike traditional mutual funds, index funds operate on a passive management approach.
This means that instead of hiring an expensive fund manager to make active investment decisions, the fund simply follows a predetermined formula.
This formula is based on an index, which serves as a representative sample of the stock market.
Indexes were developed as a tool to quickly gauge stock market performance, providing a consolidated view rather than individually tracking thousands of stocks.
The term "index fund" stems from the fact that these funds replicate the performance of an index.
In the 1970s, Jack Bogle introduced the first index fund, which closely mirrored the performance of the widely followed S&P 500 index.
Index funds offer significantly lower fees compared to traditional mutual funds because they simply replicate the stocks included in a specific index, such as the S&P 500.
By eliminating the need for expensive fund managers to make investment decisions, index funds can charge much lower fees.
For instance, if you look for VFIAX on Vanguard.com, the Vanguard 500 index fund has an annual fee of only 0.04 percent, which is relatively minimal.
It's important to note that index funds fall under the category of mutual funds, but not all mutual funds are index funds.
An index fund clearly indicates that it tracks a specific index, and its name or prospectus will explicitly state the index it follows.
For example, the previous fund, VFIAX, is labeled as an "index fund" and its prospectus specifies its objective to track the performance of the Standard and Poor's 500 index.
On the other hand, a non-index mutual fund will be described in the prospectus as one where the fund manager independently selects and manages a portfolio of stocks.
This serves as a simple way to distinguish between index funds and actively managed mutual funds.
Exchange-Traded Funds (ETFs)
ETFs were introduced around 15 years after the first index fund and share many similarities with index funds.
However, there is one significant difference:
while index funds allow you to buy and sell shares only once a day, ETFs offer the flexibility to buy and sell shares throughout the trading hours of the stock market.
Although an ETF is not technically a stock, it can be traded like one.
It's common to hear ETFs and index funds being used interchangeably, but they are not the same thing.
If you want to invest in the S&P 500, for example, you can choose between an S&P 500 index fund like the Vanguard option mentioned earlier, or an ETF like the SPDR S&P 500 ETF.
The decision you need to make is whether you require the 24/7 tradability that an ETF provides or if you are satisfied with an index fund.
From my experience, the ability to trade ETFs does not significantly contribute to long-term investing success.
The trading nature of ETFs, where their prices can be monitored on stock charts and bought and sold throughout the day, tends to foster impulsive buying and selling behaviors.
Human nature often inclines towards gambling-like tendencies, which contradict the principles of prudent investing.
Personally, I believe that ETFs can do more harm than good, as they introduce unnecessary temptation.
If you're uncertain about choosing between ETFs and index funds, my recommendation is to opt for index funds.
They essentially offer the same benefits, but without the added temptation to engage in speculative trading.
For most individuals, a simple approach of buying, holding, and selling upon retirement is sufficient, making the 24/7 tradability of ETFs unnecessary.
Furthermore, one significant reason why I prefer index funds, and it's a compelling one, is that they provide automatic reinvestment. This feature makes saving and investing effortless, requiring minimal effort on your part.
With index funds, you can establish a recurring monthly deposit from your checking account, and the funds will automatically purchase more shares for you every month.
The best part about automatic reinvestment in index funds is that it's a free feature. It's a no-brainer to automate good investing habits with this option.
On the other hand, ETFs do not offer this feature.
If you wanted to contribute more to your investments each month with ETFs, you would need to manually buy more shares, which means additional work for you.
Not to mention, you would incur trading commissions each time, which can be undesirable.
Well, I hope this article has provided you with a better understanding of mutual funds, index funds, and ETFs, along with their similarities and differences.
So just to recap, mutual funds were the first to offer the advantage of pooled investing, followed by index funds as a special type of mutual fund with lower fees and passive management.
And finally, ETFs entered the scene, trading like stocks and offering most of the benefits of index funds, with the exception of automatic reinvestment.
And that’s it, if you enjoyed the read, make sure to share with your family and friends!
- Ivan