Investors have many options when it comes to investing. From the traditional method of investing in stocks and bonds, introducing mutual funds, ETFs, and index funds add a layer of complexity. However, that complexity has also opened up many opportunities for investors to invest more efficiently.
This post will discuss three major financial vehicles that provide investors with a chance to invest efficiently.
What is an ETF?
An ETF is a type of fund which owns the underlying assets (shares of stock, bonds, oil futures, gold bars, foreign currency, etc.) and divides ownership of those assets into shares. The owners of the shares are entitled to a proportion of profits, such as earned interest or dividends paid out by the underlying assets.
An example of a popular ETF is the SPDR S&P 500, which tracks the S&P 500.
Advantages
ETFs are passively managed, so they have much lower expense ratios than actively managed mutual funds. The expense ratio difference is because index funds track an index and don’t hire a fund manager who charges a hefty fee to manage the portfolio.
Secondly, ETFs trade on a stock exchange and have high liquidity. So, for example, if you want to sell your shares in an ETF, you can get current prices and execute the trade immediately. In contrast, mutual funds and index funds are valued once a day, and you’ll have to wait till the next day to see how much your share is worth after you sell it.
The actual stocks that make up an ETF’s portfolio are public information, so investors know exactly what they’re buying into. Lastly, ETFs are tax-efficient since they don’t need to trade often to stay aligned with their indexes.
Disadvantages
One disadvantage of ETF shares is that they are much more heavily traded than mutual funds. This means that when you buy or sell an ETF, you are paying a higher price than if you bought or sold the same amount in a mutual fund.
Another disadvantage is that ETF returns can lag behind their index. If the index rises 10%, but your ETF only rises 9%, you have to wait until the next year for your return to catch up. That’s not usually a big deal; if you’re investing for retirement and can afford to hold for long periods, then a short-term discrepancy of 1% or 2% won’t make much difference to you in the long term. But if you’re investing for shorter periods, this can matter more.
What is a mutual fund?
Professionals manage a mutual fund for investors who want to achieve certain financial goals. It pools money from many people and invests in stocks, bonds, or other securities. Each mutual fund scheme has a defined investment objective and strategy, as seen in its prospectus. The returns of each scheme are dependent on its investment objective, asset allocation, and performance of its underlying securities.
For example, an equity fund will have most of its portfolio invested in stocks, while fixed-income funds will hold most debt instruments such as bonds or government securities (G-Secs).
Popular mutual funds include the Vanguard Institutional Index Mutual Fund (VINIX)) and Fidelity Government Cash Reserves (FDRXX).
Advantages
The main benefit of investing in mutual funds is diversification. An individual stock can be risky, but the diversified portfolio reduces the risk of owning thousands of stocks. This is especially important if you’re investing for the long term—you’ll have time to ride out market fluctuations.
It also allows you to access professional money managers without hiring them directly yourself. Instead, the fund staff does all the work, choosing which stocks to buy and sell.
Mutual fund investors can also save time if your goal is not long-term growth but short-term income. Instead of buying and selling individual stocks every month or so, you can open an account with a mutual fund manager who will buy and sell on your behalf.
Disadvantages
Investing in mutual funds has its disadvantages, too.
First, you have to pay a yearly fee for management and administration expenses. These can be quite high, especially if you are buying your shares through a broker or financial consultant who charges you a separate commission fee. That’s why it’s important when choosing mutual funds to check out their costs and performance records carefully beforehand.
Second, many financial experts argue that you’re better off buying individual stocks and bonds than relying on someone else to do it for you. They say you can beat the market averages with your portfolio with some study instead of paying someone else to do it for you.
They also aren’t very liquid. So, for example, if you want to sell your shares at the end of the day, or even intraday, you can’t do so because the fund itself has to sell its portfolio of stocks and then distribute the cash. This process can take up to three days to complete, depending on the fund.
What is an index fund?
An index fund is a type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor’s 500 Index (S&P 500 index) or the Nasdaq. An index fund aims to replicate the performance of an index as closely as possible without actually owning part of the assets in that index.
A popular index fund is the Vanguard Total Stock Market Index Fund (VTSAX).
Advantages
Index funds are a low-cost, diversified investment strategy that offers you instant diversification. You can gain exposure to the entire U.S. stock market by investing in one fund.
Index funds are also considered passive investments because they track an index, or large group of stocks, instead of trying to beat the market with a big-money management style. This means they benefit from infrequent trading, which can incur additional broker fees and tax consequences.
Unlike actively managed funds, which require a large staff of analysts and stock pickers to research potential investments, index funds passively replicate the securities held in their particular indexes. This means that the funds do not need to undertake significant research or trading activities and thus have low operating expenses compared to actively managed mutual funds.
The lower expenses result in higher returns for investors in index funds.
Disadvantages
One main disadvantage of index fund investing is that unless you invest in very different areas, you’re likely to have an overall portfolio with less chance of beating the market than if you had picked individual stocks yourself.
Investors may not get as high a return as if they had invested directly in individual stocks or bonds.
As a result, index funds tend to be used by investors who have time constraints or aren’t comfortable making their own investment decisions. This limits their potential returns and exposes more risk to your overall portfolio.
It’s important to note that index funds also don’t invest in private businesses and startups. If you’re looking for returns as high as those from stocks, that’s where you should look; but again, it’s hard for individuals to find ways into this asset class that doesn’t involve substantial risk or hassle.
How are they all similar?
They all share a common overall end goal
The three investment vehicles offer investors the ability to invest in multiple companies without purchasing individual securities in each company.
Overall, all three are focused on providing their investors with returns and financial gains at the end of the day.
They are all less risky than investing in individual stocks
When people invest in individual stocks, they usually take on much risk. If they are lucky, their investments pay off, and their portfolio returns are positive. If they aren’t lucky, their portfolio returns can be negative.
This is not the case with investing in any of the above vehicles. Nevertheless, they are a great alternative for beginners who don’t want to get into stock trading.
How are they all different?
The approach to achieve returns
The key difference between an index fund and a mutual fund is that a mutual fund has a manager attempting to beat the market’s return, while an index fund buys shares of companies on a predetermined index.
The minimum investment required
There is no minimum investment required for ETFs, making them a more convenient option for investors who wish to start small or do not have enough money to meet the minimum deposit requirements for a mutual fund.
Depending on the funds in question, mutual funds and index funds have minimum investments required. Unlike ETFs, you can only buy mutual fund shares from an investment company, which you can purchase on the stock market.
Trading times differ
ETFs can be traded any time during the trading day and are transparent, which means the underlying investments are known and can be looked up.
Mutual funds and index funds are also available for purchase during the day, but they must be sold at the end of a trading session.
Mutual fund shares are bought and sold at net asset value (NAV) based on the depository’s closing share price when the market closes.
Levels of passive and active management
A mutual fund has its unique advantages, such as providing management expertise that can help you optimize your portfolio. With an ETF, you are largely responsible for your own investing decisions.
Index funds are also passively managed and don’t require intervention from fund managers.
Cost differences
Mutual funds tend to be more expensive than ETFs or index funds because they involve sales commissions and additional fees.
Some mutual funds charge management fees that could be as high as 2% per year of your invested money. This is due to the portfolio managers and financial advisors actively overseeing the mutual fund company’s investments.
In comparison, ETFs and index funds can be a low expense in the long run. However, ETFs may pose higher transaction fees due to regular selling and trading.
Liquidity
ETFs can be traded throughout the day and offer the most liquidity compared to the index and mutual funds.
Tax efficiency
ETFs pay capital gains taxes as they operate like stocks. However, if the funds are held for longer than a year, investors are taxed at long-term capital gains rates.
Mutual funds tend to incur higher capital gains taxes as they are actively managed. The returns are incurred more frequently with the gains shared between all investors, even when there are losses.
On the other hand, index funds have the same securities as their benchmark indexes. The requirement to pay capital gains taxes arises only on realized profits when investors sell shares.
Risk and volatility
Since mutual funds are managed by an investment professional, they are less risky than ETFs and index funds from an investment management perspective.
But there is a greater possibility for your money to decrease in value, which is the downside with mutual funds as your money is locked up tighter due to lower liquidity levels.
ETV vs. Mutual Fund vs. Index Fund: What’s right for you
For an investor, the most important choice is what to invest in—the stock market as a whole, companies in particular industries, smaller companies, or foreign companies. Different kinds of funds offer different ways to make that choice.
When you should consider ETFs
ETFs are the best choice for investors who want to avoid the risks of investing in individual stocks, but not so much that they want to eschew individual stock market exposure completely.
ETFs may also be a good choice for investors who already have significant amounts of money invested in other vehicles—such as retirement plans—and do not want to move their funds.
ETF investors may also have time constraints, so they are a good option because they can be traded rapidly, whereas most mutual funds can only be bought or sold at the end of the day after the markets close.
When you should consider mutual funds
Mutual funds are good for people who want a long-term investment with professional management. Mutual funds typically offer more customization options and choices of asset class, which is useful for investors with specific financial goals.
For example, if you’re investing for your retirement, you might consider using a target-date retirement fund that will gradually become more conservative as you get closer to retirement age. You can also invest in load mutual funds through your employer’s retirement plan.
Finally, if you have either a large amount of money to invest or a small amount of time to devote to investing, you could hire an investment adviser to help you pick your investments. Mutual funds also have minimum initial investments, so they are suitable for those ready to make that kind of commitment.
When you should consider index funds
For investors who want to own stocks but don’t have the time or expertise to choose individual stocks, index funds are ideal. They’re much cheaper than actively managed funds, and they don’t require much maintenance either.
As long as you hold your fund, it will automatically track your chosen index.
FAQs
Why choose an ETF?
Exchange-traded funds (ETFs) offer the benefits of mutual funds and take them to a higher level. ETFs have lower costs, are flexible, and have better tax efficiency than mutual funds.
Do mutual funds outperform ETFs
Actively managed mutual funds tend to outperform ETFs in the short run, but this is not the case in the long run due to higher expense ratios and the lower probability of beating the market
What is the difference between index funds and ETFs?
ETFs are traded throughout the day like stocks, but index funds can only be purchased and sold for the price determined at the end of the day. ETFs are the best option for investors seeking intraday trading and higher liquidity.