An Introduction to ETFs, Mutual Funds, and Index Mutual Funds
By Brian Helfrich | May 5, 2022
As a new investor, you may feel daunted by the wide range of locations to put your long-term savings. It is likely not the best idea to keep your money only in a savings account with a retail bank as its interest rate is unlikely to exceed inflation. You also might not have enough time to perform hours of research and become an expert on one company or sector. A good option for you could be a pooled investment vehicle like a mutual fund, index mutual fund, or an exchange traded fund (ETF). Managers of these funds collect money from many investors and invest it on their behalf in return for an annual management fee (expense ratio). After investing in these funds, you receive a share of the total invested assets. The number of shares that you own represents your proportional ownership of the fund’s pooled assets. As the value of the pooled assets ideally grows, so does your share of the investment. If the value of the pooled assets declines, so does the value of your investment.
The biggest advantage of investing a pooled fund is that it provides you with diversification. With a larger pool of money, the fund managers can invest in dozens or even hundreds of different securities and easily rebalance the portfolio. So, if one company or sector underperforms the rest, it is more likely that a different holding in the portfolio could perform well to at least offset the underperformance of other assets. Ideally, a well-diversified portfolio grows more consistently than an overly concentrated portfolio.
When selecting a fund to invest in, you should first read its prospectus which is a document that outlines the goals of the fund, its holdings, and associated risks and fees. A key distinction between funds is that some are actively managed while others are indexed. An actively managed fund aims to outperform a preselected index or benchmark. In contest, index investing seeks to exactly match the performance of a selected index. Typically, active funds will cost more because you pay a premium for the manager’s expertise in investing.
To illustrate, imagine that the S&P500, a widely used index of 500 large US equities, went up by 10% in a year. An active fund, depending on its strategy could outperform the index or underperform it. An index fund would exactly match the index’s 10% performance before subtracting any fees. As a result, there is more downside risk when investing with an active fund, but you are compensated for that risk with more upside potential. In fact, most active managers fail to consistently beat the performance of an index fund.
So, what differentiates a mutual fund, index mutual fund, and an ETF? To start, the shares of a mutual fund are priced daily after the US stock markets close at 4:00 PM. This is because mutual fund shares do not trade on a stock exchange and are purchased directly from the managing company of the fund. Shares of an ETF however do trade on a stock exchange and are priced throughout the day like any other listed security. You buy them from a seller on the exchange. Historically, ETFs were known only as indexed products but in recent years many active ETFs have been created for investors.
An index mutual fund and mutual fund both use the same structure, but one is indexed while most regular mutual funds are active. Due to structural differences that are beyond the scope of this article, ETFs tend to have lower annual fees and tax burdens than mutual funds. In fact, some mutual funds are converting to the ETF structure due to these advantages. When investing with a long-time horizon, it is advantageous to minimize these added costs as they reduce any gains that you might accumulate from owning the shares of the fund.
Overall, all three of these fund types offer you diversified and liquid (able to be quickly converted to cash) exposure to a specific slice of the stock market. To purchase the forementioned products, begin at the websites of leading mutual fund and ETF issuers including but not limited to: BlackRock, Fidelity Investments, State Street, and Vanguard. There you will find fund prospectuses, research, and search tools to inform your investment choices.
Edited by Joseph Barbieri