Funds are often suggested as an ideal investment for new investors. The problem is that many new investors may not know the difference between the different types of funds. ETFs, mutual funds, and index funds are all similar, but each has its own unique advantages and disadvantages. If you’re new to investing or simply looking to deepen your existing knowledge, understanding the differences and similarities between these three types of funds can help you make more informed investment decisions.
If you need assistance with your finances, work with a professional financial advisor from Good Life Financial Advisors of Mt. Pleasant. We’re ready to help create a personalized plan for your specific needs.
What is a Mutual Fund?
A mutual fund is a pool of money that’s used to purchase a group of investments, typically stocks. When you invest in a mutual fund, your portfolio then has a small amount of each of the investments the mutual fund is invested in, typically hundreds or even thousands of individual securities. This makes it an amazing tool for adding diversification to your portfolio. The cost of purchasing each security individually would prohibit most investors from achieving this same level of diversification through investing in individual securities.
What is an ETF?
ETFs are similar to mutual funds in that they also allow investors to pool their money to purchase a collection of investments. What makes ETFs unique is that they are traded on a stock exchange, just like a stock. This allows you to trade ETFs more easily than mutual funds. It also makes ETFs more liquid than mutual funds, since ETFs can be bought and sold throughout the day, while mutual funds are only priced and sold once at the end of the trading day.
ETFs also open up more investment opportunities for those with limited funds, since investment minimums for ETFs tend to be lower. Mutual funds typically require a minimum amount in order to invest, which is often at least $1,000. In contrast, you can purchase an ETF for the price of a single share, which is typically far lower than the investment minimum required for a mutual fund.
What is an Index Fund?
An index fund is a type of mutual fund with the sole purpose of tracking an index. These funds typically consist of a weighted average of all the stocks in the index the fund is tracking. What makes the terminology of the different types of funds so confusing, especially for new investors, is that even though an index fund is a type of mutual fund, there are also index tracking ETFs. Even though index tracking ETFs also track an index, they are not the same thing as index funds.
One of the key differences between the types of funds is how they’re managed. Mutual funds are typically actively managed while index funds and ETFs tend to be passively managed. What’s the difference between passive and active management, and which is better? An actively managed fund has a portfolio manager whose goal is to outperform the market (or a specific sector of the market). On the other hand, a passively managed fund’s goal is to have the same performance as the index the fund is tracking.
In theory, better performance may sound more appealing, but it’s important to remember that the goal of the fund and what it achieves are not necessarily the same thing. In fact, evidence shows that over the long-term, actively managed funds fail to outperform passively managed funds. On top of that, actively managed funds tend to have more fees, which may impact the returns you see over time.
Costs vary from fund to fund, but there are a few general rules about the costs of the different types of funds. Since you trade ETFs on a stock exchange, just like with stocks, you may end up paying commission fees. May is the key word here.
In late 2019, many of the major brokerages stopped charging commissions. This means that now many, but not all, ETFs come commission-free. Commissions have an especially large impact on dividends. That’s because mutual funds and index funds will automatically roll over dividends without charging you. This is not the case for ETFs, where you’ll have to purchase additional shares. Purchasing additional shares means paying more commission fees, assuming your ETF is not commission-free.
The major cost to look out for with mutual funds is loads. Mutual funds cannot charge commissions, so they charge loads, which are essentially another way to charge commissions. A load is a commission you pay when you purchase a fund. Index funds may charge loads, but it is far less common.
Which Fund is Best for You?
The right type of fund for you, whether that’s an ETF, mutual fund, or an index fund, will depend on what you’re looking for in an investment and should be considered within the context of your financial plan. For more information about the different types of funds and which is most appropriate for you, speak with a team member from Good Life Financial Advisors of Mount Pleasant today!