6 min read
Sep 08, 2020
September 08, 2020
Comparing three of the most popular investment vehicles for the modern day investor
When you start learning about personal finance, it can be a game of alphabet soup. There are so many different abbreviations and acronyms to understand and memorize, like CD, 401(ks) and IRAs. It’s easy to feel overwhelmed.
The process doesn’t get any easier when it comes to investing. Investing is like its own language, one that may seem hard to crack from the outset. But when you look closer, you may realize that everything makes sense.
And when you’re deciding what to invest in, it’s crucial that you understand the various definitions. Here’s an explanation of mutual funds vs. ETFs vs. index funds.
All three are examples of pooled investments. They each hold a basket of stocks or bonds, and the securities in that basket have something in common. For example, they may all be tech stocks, socially responsible investments or government bonds.
The benefit of buying pooled investments is that you get a large amount of securities with every share. Instead of buying one share of Apple, you can buy a share of a tech fund that includes parts of Apple, Google and Microsoft. This lets you diversify your portfolio, even if you only have $50 to invest.
Most of these pooled investments hold hundreds or even thousands of different securities, which also minimizes your investment risk. For example, if you only have shares of Tesla in your investment portfolio, your risk is high. If Tesla shares drop, your entire portfolio could be in danger. But if you buy a fund with 500 different stocks including Tesla, you may not even notice a difference if Tesla starts doing poorly.
Depending on your particular investment firm, you may be able to pick from all three options (mutual funds, ETFs and index funds) for your retirement account. Whether you have an employer-sponsored 401(k) or an IRA, you should be able to invest in mutual funds, ETFs and index funds.
However, if you have a Solo 401(k) or SIMPLE IRA, you may not have any ETF options. This depends on the company you have an account with and their individual rules.
Mutual funds are created by people whose job it is to choose the best stocks or bonds and outpace the market. Because these funds are actively-managed, they have higher fees than passively-managed funds like index funds and most ETFs.
Active Investing — Investors who choose actively-managed mutual funds do so because they believe that an active approach yields better returns than a passive approach. However, this hasn’t been proven over a significant period of time.
Liquidity — Mutual funds are somewhat less liquid than ETFs because they can only be sold at the close of the business day. If you want to sell a mutual fund at noon, you’ll have to wait until the markets close to conduct the sale.
Poor Affordability — Mutual funds also often have a higher initial minimum investment amount, ranging from $500 to $3,000. This can make it difficult for new investors to get started.
Target-date funds are one popular subset of mutual funds. Target-date funds are grouped by date and are designed as a “set it and forget it” type of investing. If you’re a 25-year-old you might choose a target-date fund with a 2060 end date.
Target-date funds automatically rebalance as the date gets closer. They always start out heavily weighted toward stock funds and gradually incorporate more and more bond funds. Toward the end, they may be almost exclusively invested in bond funds.
Target-date funds are popular with beginner investors or those who can’t afford a financial planner to pick and choose a specific mix of funds.
ETFs or Exchange Traded Funds are baskets that contain hundreds of different stocks, bonds or commidities and track a particular index. ETFs may follow a certain index, similar to index funds, or a particular industry sector. You can have an ETF that only invests in companies with an environmental angle or ones that focus on female-led companies.
“Most ETFs replicate the performance of a particular index like an index fund,” said Jovan Johnson, MBA, CFP®, CPA/PFS of Piece of Wealth Planning LLC.
Liquidity and Real-Time Pricing — Unlike mutual funds, ETFs can be sold at any time during the day, similar to individual stocks; meaning they have the advantage of real-time pricing. Like mutual funds, ETFs also hold a variety of stock or bond funds.
Fees — ETFs usually have the least amount of fees compared to mutual funds and index funds. For example, the Vanguard Total Stock Market ETF (VTI) charges a 0.03% fee while the Vanguard Total Stock Market Index Fund Investor Shares has a .14% fee.
Most robo advisors almost exclusively invest in ETFs for their low fees and passive approach. If you’re new to investing and don’t have a lot of money, ETFs are a good choice to get started.
Tax Efficiency — “ETFs are generally tax-efficient, meaning they can exchange securities in-kind with incurring little to no capital gains,” said Dan Herron CPA/PFS CFP® of Elemental Wealth Advisors. “With mutual funds or index funds, they have to sell underlying securities with the funds, which can create capital gains.”
The first index fund came about in the 1970s with Vanguard, and they’ve grown in popularity since then. Famed businessman Warren Buffett has frequently espoused the benefits of index funds. His will states that when he dies, 90% of his estate should be invested in index funds.
Investors like Buffett recommend index funds because they track the index and allow regular people to replicate the market’s returns. An index fund tracks a particular stock market index, like the S&P 500. It may also track a large number of the same types of securities, like all US bonds or all US stock.
Index funds may have higher minimum investment requirements than ETFs. Like mutual funds, they can only be bought or sold at the end of the day.
Passive Investing — The most notable difference between an index fund and a mutual fund is the investing style. While mutual funds rely on the wiles of the fund manager to judge market conditions and make trades, index funds are a passive approach to investing, with trades reflecting the movement of the index itself.
On the other hand, index funds and ETFs are both similar in that they are both considered passive investing strategies.
Liquidity — “Index and mutual funds do not trade like stocks, but are bought and sold at a price that is set at the end of the day, based on the net asset value (NAV) of the underlying securities,” Herron said. ETFs, on the other hand, are much more flexible and can be traded at will, much like a stock.
Fees — Given the lack of manual oversight, index funds are more affordable for the average investor. Mutual funds are created with the intention to beat the market; higher risk means potentially higher rewards, a gamble that mutual fund investors are ready to pay up for.
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