What is the difference between mutual funds from index funds and ETFs. All of these vehicles are different but similar, with their own pros and cons. We hear a lot of these words being tossed around and in reality a lot of people mixing them up so I know it can be confusing.
I’ve got a degree in finance, but at school I didn’t even learn that stuff. When I first invested in ETS, I found later that ETFs didn’t have this one very important function I wanted in my portfolio of investments, so I had to turn to index funds and it was all kind of a challenge. I want to save the trouble for you! In this article I would like to share with you what I have learned so that you can be more educated before making any investments of your own.
So if you want to learn the difference between index fund mutual funds and ETFs, and which alternative could make the most sense to you, keep reading. So let us get into it right. I will start with the mutual funds because they’ve been around for the longest time. Mutual funds came a long way before index funds and ETFs and apparently the first known mutual fund was created back in the 1800’s. They were developed as a way for a lot of people to pool their money together and make investments.
Mutual funds offers three major benefits:
1.The first is convenience.
By investing in a mutual fund you get to own a bunch of different stocks all in one easy package. A Mutual fund could have hundreds of different stocks in it But you only have to make one Purchase. In a world without mutual funds, if you wanted to have say a hundred different stocks in your portfolio You’d have to make 100 separate purchases Which means you pay trading commission a hundred times and you’d waste a lot of time sitting in front of the computer Clicking the Buy button a hundred times. So inefficient, right? But by investing via a mutual fund you get instant ownership in all the stocks the mutual fund already Owns.And owning a lot of stocks all at once gives you diversification, which is the second major benefit of mutual funds.
You get to buy a lot of different stocks all in one simple bundle by investing in a mutual fund. A mutual fund may contain hundreds of different stocks, but only one investment needs to be made. In a world without mutual funds, if you were to sell a hundred different stocks in your portfolio, you would have to make 100 separate transactions, which means you pay a hundred times the trading commission and you would spend a lot of time sitting in front of the machine Pressing a hundred times the Buy button. Too ineffectual, right? But by investing in a mutual fund you get immediate ownership of the mutual fund Owns in all stocks already. And buying a lot of stocks at once gives you diversification.
Diversification is a strategy which reduces your risk of investing by spreading your eggs. Rather than investing all your money in one stock that’s the equivalent to putting all your eggs in one basket, you ‘re spreading your money around several different stocks. Even if one of the stocks in the mutual fund collapses entirely, you’ll still be fine, since each stock is only a small portion of your total portfolio. Mutual funds usually consist of at least 90 stocks, even they offer a lot of diversification that would be impossible to achieve on your own.
3.Managed by investment professionals
The third advantage of the mutual funds is that the investment professionals manage them. But instead of trying to find stocks on your own, you’ve got some crazy smart guy who obviously knows what he’s doing to pick the stocks for you. This means that mutual funds provide flexibility, diversification and access to experienced investment managers. But that doesn’t mean that mutual funds are good at 100 per cent. Convenience and diversification are certainly good advantages, but the issue with experienced fund managers is that they are charging a lot of fees.
If some very smart, well-educated specialist selects stocks for your mutual fund, it’s called “active management.” In exchange for handling your money you charge an annual fee of one to two per cent of your account balance per year.
So if you’ve invested $10,000 in a mutual fund at 2 per cent, $200 of it goes directly into the hands of fund managers. And even though the manager makes bad investment decisions and the balance of your account goes down next year, you are only fined 2%. So basically you might end up with less money than you began with But the fund manager will still get millions of dollars charged for their services. And even if you’re finding a fund manager who’s been doing really well for a couple of years, their success generally doesn’t last long-term, and the fee cost can really add up. Fees will raising your nest-egg by hundreds of thousands of dollars over the years.And the vast majority of mutual funds are not worth the high fees at all.
It was then that the index fund arrived. One day a guy named Jack Bogle Got was so sick of ripping people off mutual funds that he created a whole new type of mutual funds called Index funds. And the index fund has fully revolutionized the investment environment. Index funds are dynamically controlled, as opposed to conventional mutual funds. This means that the fund follows a predetermined formula that fully removes the need for someone to make buying and selling decisions rather than paying an expensive fund manager to do the active management.
The formula that follows is based on an index, and from this comes the name index fund. An index is a stock market representative survey, and indexes have been developed as a method for rapid measurement of stock market results. Rather than looking separately at thousands of stocks, an Index is just one specific thing you can look at to only see how the stock market did that day.
Thus Jack Bogle developed the first index fund in the 1970s, mirroring the S&P 500 index which is one of the world’s most widely followed indexes. Since the fund is actually buying whatever stocks are in the S&P 500 index, the costs are much smaller and you don’t pay for professional investment managers to make these decisions. The Vanguard S&P 500 index fund charges four per cent point zero annual fee.
Peanuts!-Peanuts! Thus index funds are a kind of mutual fund. Both index funds are mutual funds, but the index funds are not all mutual funds. An index fund explicitly shows that it tracks an index, and states the index it monitors. On Vanguard com, for example , if you look up VFIAX, it says here in the title “index fund,” so it’s very clear that it’s an index fund. And if you look at the fund’s prospectus It clearly says, “Fund employees in indexing investment approach designed to track the performance of the Standard and Poor’s 500 index is a commonly accepted measure of US stock market results.”
It’s not getting any more noticeable. But the prospectus will say something like this for a mutual fund that is not an index fund: “Advisor Separately selects and manages a portfolio of common stocks for the fund.” So that’s kind of how you can, in a nutshell, differentiate between Mutual Funds that are index funds and Mutual Funds that are actively managed and so are not index funds.
To switch directly to ETF Also known as exchange-traded funds. ETFs were launched about 15 years after the first index fund and are somewhat similar to index funds Except for one big difference: you can buy and sell shares only once a day with index funds. But you can buy and sell your shares with ETFs whenever the stock market is open even though an ETF isn’t really a stock that you can buy and sell as though it were a stock.
You can hear the words ETFs and index funds used interchangeably a number of times but they are not the same thing. If you wanted to invest in the S&P 500 you could either go with an S&P 500 Index fund like the one I listed earlier in the Vanguard, or go with an ETF like the SPDR S&P 500 ETF. The question you have to ask yourself is do I need the 24/7 trading capability offered in ETF, or am I just good at an index fund? In my experience trading ETFs doesn’t really help you achieve long-term investment success.
Given the fact that it behaves like a stock and you can watch it go up and down on a stock chart It really just promotes impulsive buying and selling and human nature has a propensity to behave like gambling, which is clearly the opposite of smart investment. So I personally think that ETFs are doing more harm than good, and you know why they are struggling with the additional temptation? So if you’re not sure whether you should go for ETFs vs index funds then I’d recommend that you simply pick index funds.
They ‘re basically the same thing, except you’re not going to have the additional urge to gamble with your money. Most people are just going to have to purchase once, keep and then sell when they retire so you don’t really need an ETF’s 24/7 tradability. Another reason why I really like index funds and that’s a big reason why I moved from ETF to index funds is that index funds offer automatic reinvestment.
This makes saving and spending very easy for you Without even raising a finger. Index funds allow you to set up a monthly recurring deposit from your checking account and they will automatically purchase more shares per month for you. The best thing is there’s no extra charge for doing this. This is a free automated reinvestment feature and it makes automating healthy investing habits a no brainer for you.
ETFs do not provide this option if you want to make more of a monthly contribution to your fund. Every month you will have to buy more ETF shares which means more work for you. Of course, it means that you will have to pay trading fees, and who wants to do that? So I hope you understand more about the mutual funds, index funds, ETFs and what similarities and discrepancies they have.
Mutual funds came first and they introduced the value of pooled Investing, then index funds came along as a special form of mutual fund with much lower fees and a method of management called Passive Management, and then finally the ETF came onto the scene which trades like a stock and offers all that index funds offer except automatic Reinvestment. If you have any questions about what I have been talking about in this post, please let me know in the comments and I will be sure to get back to you.