Are you interested in investing in the stock market but don’t want to spend countless hours analyzing and picking individual stocks? What is the difference between mutual funds, index funds, and ETFs? More importantly, which one should you use in your investment strategy?
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This article will explore each of these investment vehicles that you can use to invest in the stock market passively.
A mutual fund is a way for people to pool their money in to invest in stocks and bonds. The concept of pooling funds to make investments together spans several centuries and nations.
Fun Fact: A Dutch merchant called Abraham van Ketwich created the earliest mutual fund for citizens of modest means in the 18th Century. This first fund owned bonds and plantation loans.
While the basic concepts have not changed, mutual funds have continually evolved over the years. Index Funds and ETFs originated from Mutual Funds.
There are 7 main types of mutual funds, discussed below.
1. Money Market Mutual Funds
Invest in highly liquid short-term investments, including treasury bills, cash, and cash-equivalent securities. They offer a low level of risk and, consequently, a low return. Money market mutual funds are ideal for parking surplus cash for a short while and are not suitable for long-term investing.
2. Equity Mutual Funds
These are mutual funds that invest in stocks. They are also known as stock funds. They provide a high return and carry a higher risk as a result. There are various types of equity funds, including growth stocks, income funds, value stocks, large-cap stocks, mid-cap stocks, and small-cap stocks.
3. Fixed Income Mutual Funds
Invest in securities that pay investors set interest or dividends until their maturity. Upon the maturity of such securities, principal gets repaid to the investors. Examples of fixed income securities include government and corporate bonds.
4. Asset Allocation or Balanced Mutual Funds
As the name suggests, these funds have holdings balanced between stocks, bonds, and money market components. They are suitable if you are looking for a mixture of safety (from money markets), income (from fixed income securities) and, capital appreciation (from stocks).
5. Index Funds
An increasingly popular type of mutual fund designed to mirror a particular market index such as the S&P 500, NASDAQ, Dow Jones Industrial Average, etc. When you buy an index fund, you become a partial (albeit small) owner of all the companies included in that particular index.
6. Specialty Funds
Invest in predominantly or exclusively in a single sector, industry, or region of the world. Specialty areas could include real estate, socially responsible investing, energy, etc.
As the name suggests, these types of mutual funds invest in other mutual funds.
ADVANTAGES OF MUTUAL FUNDS
- Diversification: mutual funds reduce your investment risk by holding multiple assets within them, typically 50 to 200 different securities.
- Convenience: Fund managers take care of researching the investments, asset allocation, and management, making mutual funds easy investments.
- Liquidity: It is easy to buy and sell mutual funds through mutual fund companies and various brokers. Mutual funds transactions happen once a day.
DISADVANTAGES OF MUTUAL FUNDS
- High Expense Ratios: Mutual funds charge for expert management provided by the fund managers. Mutual funds may charge a “load”, the cost to get in and out of a fund. Fees reduce your overall return, and therefore, you need to pay particular attention to this cost.
- Loss of control over investments: Mutual funds are run by money managers who make all investment decisions within the fund. As such, you cannot control how and where your money gets invested.
- Manager Risk: Being human fund managers may be susceptible to hubris, greed, complacency, etc. Further, while their mandate is to outperform the market, few managers can do so consistently (if at all).
Check out these related articles:
- 5 Reasons to Start Investing Today
- How to invest: Stock Market for Beginners
- Should You Invest or Pay Off Debt?
INDEX (MUTUAL) FUNDS & ETFs
Index Funds and ETFs were both born out of the Mutual Fund concepts and are very similar. Due to their similarity, many people often use their names interchangeably. However, they do have a small difference, explained in the following definitions.
Index funds are a type of passively-managed mutual fund designed to mirror the composition and performance of a financial market index. Non-index mutual funds, on the other hand, aim to beat the market and are actively managed.
History of Index Funds (Fun Facts):
- Jack Bogle, the founder of the Vanguard Group, popularized index investing.
- Vanguard offered the first-ever index mutual fund to the general public in 1976.
- You can learn more about index investing straight from the source by reading this book:
- The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns by John C. Bogle
- Also check out the Vanguard site here.
EXCHANGE-TRADED FUNDS (ETFs)
Similar to mutual funds, ETFs also invest in various securities such as stocks and bonds. While ETFs can use different investment strategies, they often track an underlying financial market index. This latter aspect makes ETFs very similar to Index Funds.
ETFs and Index Funds’ main difference is that ETFs are listed on exchanges and can trade throughout the day. The price of an ETF fluctuates throughout the day, just like a common stock. You can place an order for Index Funds (and all other Mutual Funds) at any time during the day but their price is determined daily after the market closes.
ADVANTAGES OF INDEX FUNDS & ETFs
- Low fees: Since the index fund manager’s only mandate is to track a particular market, it eliminates the analysis and management involved in actively managed funds. As such, index funds operate at a minimal cost.
- Passive management: Due to low cost and minimal manager risk, index funds tend to outperform actively managed funds. Below is a quote by the legendary investor, Warren Buffet, in his 2014 shareholder letter: “Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades. A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.”
- Broad diversification: Index funds offer broader diversification than actively managed funds as they have a high number of holdings (holdings of entire market indexes). Generally, more diversification provides a lower risk.
- Lower tax exposure: Index funds do not buy and sell investments frequently since the underlying indexes do not make changes often. In contrast, non-index fund portfolio managers buy and sell investments frequently, resulting in taxable income passed along to the investors.
“Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades. A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.”
DISADVANTAGES OF INDEX FUNDS & EFTs
- Low Flexibility: Since an index fund mimics an index, there is no flexibility to trim under-performers or add better-performing securities
- Cannot Outpace the Market: By their very definition, index funds can only do as well as the market performs. Actively managed funds, in contrast, can beat the market in a given year. However, the performance of actively managed funds varies and cannot outpace the market consistently.
Mutual Funds, Index Funds, and ETFs offer various advantages for a beginner investor. While everyone’s investment needs are different, Index Funds & EFTs offer a more attractive form of passive investing. Ultimately, investment decisions are personal, and you should always do your research to decide which investments best meet your needs, preferences, and goals.
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“Don’t look for the needle in the haystack. Just buy the haystack!” ~ John C. Bogle
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