Should I invest in a mutual fund, index fund, or in ETF?
In my previous post about funds, I mentioned that there are mainly four main types of funds. These are mutual funds, exchange-traded funds or ETFs, index funds, and hedge funds.
Today we will look more closely at each one of these funds but will focus on the first three types. Hedge funds are for very wealthy people, so let’s not worry about those for now.
Also, for comparison purposes, we will only look at funds that invest in stocks or what we call equity mutual funds for simplicity.
We will learn how these three funds are similar and how they differ from each other. I think it is good to know their characteristics because often people don’t know the distinction and use them interchangeably.
So let’s start with mutual funds- the oldest of all three!
Mutual funds have been there for the longest time. The first mutual fund was created in the U.S. in 1924.
You can buy mutual funds from mutual fund companies or through stockbrokers. The price of a mutual fund is set at the end of each trading day based on its net asset value or NAV.
Benefits of mutual funds
The main benefit of a mutual fund is the diversification it offers you. Diversification is an investing strategy that reduces your risk by spreading out your portfolio. I talked about this in my earlier post, that you don’t want to put all your eggs in one basket. By investing in a mutual fund, you get a tiny slice of each of those companies that are in the fund.
The other benefit is convenience. Investing in a mutual fund reduces your cost and the transactions you have to do. When you invest in mutual funds, you only make one purchase when you start. You get a share of each of the stocks that are in the fund, without having to pay a commission on each company’s stock trade. You can then invest more money in it periodically.
Without a mutual fund, if you want to buy a lot of stocks, this will involve a considerable amount of your time and money.
Are there any cons of investing in a mutual fund?
The second key feature is that mutual funds are mostly actively managed Funds. What do we mean by actively managed?
It simply means some finance professionals are doing the research and selecting the stocks for you based on their judgment. The main aim of these professionals is to pick and choose securities that can beat the market return. For their service and time, they typically charge you 1%- 2% of your account balance annually.
This is irrespective of the performance of that fund. So, even if the stocks they chose in the fund are not performing well and your account balance goes down, you still have to pay the fees annually.
This 1%-2% fee might seem low but if you have a bigger balance, then this will eat into your invested money over time.
Also, historically, the data shows that most of the time these fund managers are not good at beating the market. This means that the stocks that they cherry-pick do not give you better returns than the broad-based market index such as the S&P 500 index.
Mutual funds also have some holding restrictions in terms of the minimum duration of time you need to hold the fund. There could be a penalty if you sell it before that time depending on the type of mutual fund.
Let’s look at index funds now!
An American investor, John Bogle created the first index fund that mirrored the S&P500 index in Dec 1975. He believed in a long-term investing strategy over day trading and speculation. He also didn’t like paying high unwanted fees to mutual fund managers. So, an index fund was a perfect solution!
Thus, unlike traditional mutual funds, Index funds are passively managed funds. They just track a certain market index such as S&P500, Dow Jones Industrial Average, or some other index. This is how they got their name index funds. Simple, right?
Index funds buy and sell securities based on the index they copy. So, their portfolio will reflect any type of change in the index they follow.
Here, I would argue that for a beginner investor, an index fund would be a better choice for many reasons. Even investing experts like Warren Buffet favors index funds.
Advantage of an Index fund
First, they are very well diversified because they invest in all the stocks that make up an index.
Another advantage of investing in index funds is that they are passively managed and have incredibly low fees. Vanguard S&P 500 index fund has fees as low as 0.04%. The main reason for that is you don’t have to pay the brokers and research analysts to pick and choose companies to invest in.
Data has shown that Index funds are less volatile and give decent returns over the long run compared to individual stocks. Thus it makes sense to make these the main part of your portfolio, especially for retirement accounts like 401k and IRA.
You know what is really cool about index funds is that they allow you to do automatic reinvestment. You can set up a monthly recurring deposit from your bank account to the fund. This is a free automated feature and goes well with the dollar cost averaging strategy of investing.
Are there any disadvantages of index fund?
The only limitation of index funds is that some of them like the Vanguard 500 index fund VFIAX have a minimum requirement of $3000 for investment.
But a lot of other options like those from Charles Schwab and Fidelity index funds don’t have any minimum constraint.
VFIAX is one of the most popular index funds. As S&P 500 stock market index is a widely recognized benchmark for US stock market performance. Rather than looking at individual companies’ performances, you can simply look at the index direction, whether it’s going up or down.
Here are the top three S&P 500 index funds I found that you can check out. You will find expense ratio and minimum investment requirements, dividend yields, and 5-year trailing return comparison.
Moving on to the newest category of funds, the exchanged traded funds or the ETFs.
Exchange-traded funds have features of both index funds and stocks. They were first created in the 1990s.
ETFs like index funds can mimic a variety of indices such as the S&P500 or medium or small companies indices.
The added feature of ETFs is that they trade on a stock exchange. However, these are still usually passively managed like index funds.
Also, you don’t need a large amount of money to start investing. You only need enough to buy an ETF for the price of one stock, which could be from $50 to a few hundred dollars.
Since ETF trades like a stock, its price can fluctuate throughout the day. Depending on what time you’re buying or selling that’s the price you pay or receive.
So the difference is the option of intraday trading in ETF versus end-of-the-day trading in a mutual fund or index fund.
So is that even worth it?
But this flexibility might not be good for long-term investing. The reason is that when you see the price of ETF going up and down you will be tempted to sell and buy, but this is not what long-term smart investing preaches. Most people just buy once and sell when they retire, so this added feature doesn’t help.
Another downside if you compare them with index funds is that ETFs don’t have the automatic reinvestment feature as index funds do. You manually have to buy more shares of ETF every month which means more fees and more work.
Also, some ETFs could also be actively managed mutual funds. Actively managed ETFs have expense ratios just like mutual funds. So actively managed ETF costs more than a passively managed index ETF.
How do you make money from these funds?
So how do we make money from Mutual funds, index funds, or ETFs? Just like stocks do, through dividends and or capital appreciation. So if you sell your fund for more than what you bought, you’ll make money. You’ll also benefit if the securities in your fund pay dividends or interest.
Which type of fund is the right choice for you?
To summarize, first, we only had mutual funds, which gave everyone this convenience and diversification of pooled investment.
Then came the index funds, which are passively managed mutual funds and mimic an index. Index funds, over the long run, actually perform better than actively managed mutual funds. Also, index funds have much lower expense ratios and fees.
Remember, all index funds are mutual funds, but not all index funds are mutual funds.
Lastly, we have the ETFs which have everything an index fund does with an added option of intraday trading. However, ETFs don’t have an automated option for reinvesting and you have to manually do it every time.
From a tax point of view, mutual funds incur more taxes than ETFs.
So out of three options, my choice would be to invest in an index fund. But I would still recommend you do more research before you make any investment decision.
Last but not the least – Hedge funds
Before closing, I want to quickly go over Hedge funds with you. Hedge funds originally were aimed to hedge risk but now have become high-risk high return types of actively managed funds.
Also, they are mostly meant for institutional investors and rich people. This is because their minimum requirement for investment is a huge amount of money. Most of us will not even qualify for an investment in a hedge fund.
So there you have it, my friends, your must-have knowledge of different types of funds to begin or improve your investing journey. I hope you found this information useful. Please share your feedback in the comment section below.
Disclaimer: The information presented here is for educational purposes only. I am not a financial advisor and do not provide investment advice on an individual basis.
Credits: Images from https://www.freepik.com
