Home > Investing > All About the Funds: ETFs vs Mutual Funds vs Index Funds

All About the Funds: ETFs vs Mutual Funds vs Index Funds

Do you think the topic of investing is confusing? Not sure where to begin? Then you are in the right place! It’s all about the funds…

Start investing with an index fund!

A fund is an investment that contains many assets such as stocks, bonds, commodities and other securities that trade in the stock market. A fund allows individual investors to buy assets of many different companies all at one time. The main difference between buying a fund and buying assets directly in the stock market is that the investors do not own the assets of the companies directly. The investors own a share of a “bucket” that holds the assets from different companies.

Think of a fund as buying a variety pack of candy. When you buy a variety pack of candy, you get to enjoy many different flavors all at one time. The same applies to a mutual fund, an Exchange Traded Fund (ETF) and an index fund. Each type of fund gives you the opportunity to spread a small amount of money across a large amount of assets. As an investor, your risk of loss is also spread across all of the companies in the fund, instead of just one asset. That is the idea of diversification.

If you only had $1000 to invest today and you wanted to buy one share each of Amazon, Facebook, Google, and Netflix, you wouldn’t be able to because it’s too expensive! As of June 2017, Amazon and Google stock each hit $1000 per share. However, there are many investment funds that cost under $200 per share that hold Amazon, Facebook, Google, and Netflix. If you bought one of these funds you could now afford at least five shares of the “bucket” or fund containing all of your favorite stocks.

Many people use funds as a way to diversify investment risk across companies. Be careful! Although a fund may be diversified across companies, the fund may not be diversified across industries. For example, if a fund holds all technology companies, the fund will experience big price changes (negative and positive) when there are big events in the technology industry. Similarly if the fund holds all financial companies, it will experience a lot of price movement (negative and positive) if there are big events in the financial industry. The reason this happens is because companies in the same industry are all related (i.e. correlation).

The three types of funds discussed in this post are index funds, mutual funds and exchange traded funds or ETFs:

  • Index funds

An index fund is a type of ETF or mutual fund. The purpose of an index fund is to track an index (e.g. the Dow Jones Industrial Average, the NASDAQ, the S&P 500, etc.) Assets of companies that are in the index are bought and held in the index fund. The goal of the fund is to perform similar to the index it is tracking.

  • Mutual funds

A mutual fund is a fund created by a company and actively managed by a fund manager. The fund manager determines what assets will be bought and held by the fund. The fund manager also makes decisions about when each asset will be bought and sold. The fund manager charges a fee to all investors in the fund for this service.

Most employee 401(k) plans contain a choice of mutual funds. Some of these mutual funds are also index funds. Mutual funds must be bought through your brokerage or directly through the company that manages the mutual fund. In the case of your 401(k) plan, your employer establishes a relationship with a broker that has a relationship with the mutual fund company. This allows you to invest in the fund based on your employee status.

  • Exchange Traded Funds or ETFs

An ETF is a fund created by a company and passively managed by the company. Once the company determines what investments will be inside the fund, the fund makes sure that the assets in the ETF always stay in balance. For example, if an ETF owns 60% of stock A and 40% of stock B, the company will make sure that every time an investor buys a share of the ETF, the total assets in the ETF always hold 60% of stock A and 40% of stock B. All of this is done electronically when an investor buys the ETF. Unlike a mutual fund, an ETF or index ETF can be bought and sold directly in the stock market.

Because an ETF does not have a fund manager, the fees an ETF charges are lower than the fees charged by a mutual fund. As a result, investors get to keep more of the profits when investing in an ETF instead of a mutual fund.

  • Leveraged Exchange Traded Funds or ETFs

A Leveraged ETF uses debt and other risky assets to increase the return on the fund. The return is usually 2x or 3x the return on the index. These funds are used by traders because they are cheaper to use than margin. Although it is tempting to buy these funds to gain higher returns, these funds are not meant to be used as long-term investments.

The main differences between a mutual fund and an exchange traded fund are listed in the table below.

Exchange Traded Fund (ETF) Mutual Fund
Availability / Access Can be bought and sold directly in the stock market by anyone Must be bought and sold directly through the mutual fund company; or through a brokerage that has a relationship with the mutual fund company
Price Calculated regularly throughout the day based on the prices of the assets in the fund. Sometimes an ETF trades at a price above or below its real value. When this happens the ETF is trading at a premium or discount to its real value. The price is called Net Asset Value (NAV). NAV is calculated at the close of the trading day.
Fees Lower Higher
Management Passive Management: trades are made electronically throughout the day as investors place buy and sell orders in the stock market Active Management: trades are placed at the end of the day by the fund manager
New Cash New cash is always used immediately to buy more assets for the ETF when the investor makes a purchase Cash may be held until the fund manager decides to use it to buy assets for the fund
Liquidity Can be bought and sold directly in the stock market anytime during trading hours Must be purchased after the close of the trading day. Investors have less control over the buy and sell price.
Tax Event The investor controls tax events such as capital gains / losses when the investment is bought or sold in the stock market. Tax events such as capital gains / losses are generated by the fund manager and passed on to you as an investor

 

Below are tips that new investors should consider when beginning their investment journey.

Start with an index ETF that tracks the Dow Jones Industrial Average (DJIA)

The DJIA holds 30 stable companies in various industries. Each company has a proven track record of success over many years. Index ETFs that contain these companies can outperform many individual stocks over a long period of time. Please research the ETF to understand the type of investment you are purchasing. Make sure the ETF is not leveraged.

 

See Index ETFs that track the Dow Jones Industrial Average for the three index ETFs in the chart below. DIA is an example of a great ETF. The ETFs, UDOW and DDM, are leveraged. They provide substantial returns but are not meant to be long-term investments.

Look at the Annual Return

The most important way to determine if the ETF is a good investment is to:

  1. compare the annual return to similar ETFs in the industry, or
  2. compare the annual return to US stock indexes that contain similar companies.

Many online brokers include this information in a stock screener or ETF screener as part of their research tools.

Consider how much fees the ETF charges

  • ETFs that charge lower fees means more money in your pocket!

Look at the types of companies inside the ETF

  • Based on the ETF’s strategy, determine if you want to be invested in all of the companies in the ETF on a long-term basis before buying.
  • The performance of the investments that have the heaviest weight in the ETF will have the strongest affect on how the ETF performs.

Create a diverse portfolio with a few ETFs

  1. Each ETF you select should have a different group of companies.
  2. Narrow your list to two or three ETFs that have the highest returns within their asset group over a time period of at least 1-5 years. When selecting an ETF I like to see how the fund performed over a 10-year period because it includes performance during the financial crisis of 2008. Remember all investments have cycles of ups and downs. Choosing ETFs that survived a big economic shock will ensure your portfolio can make it through a storm.

Online Resources

If you do not have an investment account yet, check the below resources to search for ETFs.

 

Final Takeaway: Remember, don’t wait too long to start. Time is money. 

Invest in Yourself, not Just Wealth™!

Check Also

How to Open a Brokerage Account

A brokerage account (also called a trading account or investment account) is an account at a licensed and …

Do It All Girl™ appreciates your comments!

Leave a Reply

Your email address will not be published. Required fields are marked *

Loading Disqus Comments ...
Loading Facebook Comments ...