What's the difference between index funds mutual funds versus ETFs. Each of these are different but similar
investment vehicles with their own pros and cons.
We hear these terms get thrown around a lot, and actually a lot of people mix them up
So I know it can be confusing.
I actually have a degree in finance
But I didn't even learn this stuff in school. When I invested in ETS for the first time
I learned later on that ETFs didn't have this one really important feature that I wanted in my investment portfolio,
So I had to switch over to index funds and it was all kind of a hassle.
I want to save you this trouble! In this video
I want to share everything I learned with you so that you can be more informed before making any investments of your own.
So if you want to learn the difference between index funds mutual funds and ETFs, and
Which option might make the most sense for you then keep on watching.
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I'm gonna start with mutual funds because they've been around the longest.
Mutual funds came way before index funds and ETFs and the earliest-known mutual fund was supposedly invented way back in the
1800s. They were created as a way for a bunch of people to pool their money and make investments together.
Mutual funds offers three major benefits:
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.
Diversification is a strategy that reduces your investing risk by spreading out your eggs. Instead of having all your money in one stock
Which is the equivalent of putting all your eggs in one basket you
Spread out your money of across many different stocks. That way if one of the stocks in the mutual fund totally crashes
you'll still be fine, because each stock is only a small portion of your overall portfolio. Mutual funds typically consist of around
90 stocks at a minimum,
So they provide a lot of diversification that would be hard to replicate on your own.
The third benefit of mutual funds is that they're managed by investment professionals.
So rather than try to find stocks on your own, you have some super smart guy who
Supposedly knows what he's doing pick the stocks for you. So mutual funds offer convenience,
diversification, and access to professional money managers.
But that doesn't mean mutual funds are 100 percent amazing. Convenience and diversification are definitely good benefits
But the problem with having professional fund managers is that they charge a lot of fees. When some really smart well-educated
Professional is picking the stocks for your mutual fund, that's called "active management". In return for managing your money
actively managed mutual funds charge an annual fee of one to two percent of your account balance every year. So at 2% if you invested
$10,000 in a mutual fund,
$200 of that goes straight into the fund managers pocket. And even if the manager makes poor investment decisions and your account balance actually goes
Down next year, you still get charged 2%. So you could literally end up with less money than you started with
But the fund manager would still get paid millions of dollars for their services.
And even if you find a fund manager who's done really well for a couple of years
Their performance usually doesn't last over the long run, and the cost of fees can really add up.
Over the years fees will reduce your nest egg by hundreds of thousands of dollars.
So the vast
Majority of mutual funds are totally not worth the high fees. Then came the index fund. One day a guy named Jack Bogle
Got so sick of mutual funds ripping people off that he invented a whole new category of mutual funds called
Index funds. And index fund totally revolutionized the investing landscape. Unlike traditional mutual funds,
Index funds are passively managed.
This means that rather than paying an expensive fund manager to do active management,
The fund follows a fixed formula that totally eliminates the need for someone to make buying and selling decisions.
The formula that it follows is based on an index, and that's where the term index fund comes from. An index is a
Representative sample of the stock market and indexes were created as a tool to quickly measure stock market performance.
Rather than looking up thousands of stocks individually, an
Index is just one simple thing
You can look up to just see how the stock market did that day.
If you're not sure what a stock market index is, then make sure to check out this video right here for an in-depth explanation.
So Jack Bogle created the first index fund in the
1970s, and it mirrored the the S&P 500 index which is one of the most widely followed indexes in the world.
Since the fund simply buys whatever stocks are in the S&P 500 index,
The fees are much much much lower because you're not paying for expensive fund managers to make these decisions for you. The Vanguard S&P
500 index fund charges an annual fee of point zero four percent. Peanuts!
So index funds are a type of mutual fund.
All index funds are mutual funds, but not all mutual funds are
index funds. An index fund will clearly state that it tracks an index, and it will specify which index it tracks. For example on
Vanguard com, if you look up VFIAX it says here "index fund" in the title
So it's pretty obvious that it's an index fund. And if you look at the fund's prospectus
It specifically states, "The fund employees in indexing investment approach designed to track the performance of the Standard and Poor's
500 index a widely recognized benchmark of US stock market performance."
It doesn't get any more obvious than that.
But for a mutual fund that is not an index fund the prospectus will state something like this:
"Advisor
Independently selects and maintains a portfolio of common stocks for the fund."
So that's kind of how in a nutshell you can distinguish between
Mutual funds that are index funds and mutual funds that are actively managed and so are not index funds. Moving right along to ETF
Also known as exchange-traded funds.
ETFs were introduced about 15 years after the first index fund, and they're very similar to index funds
Except for one major difference: with index funds you can only buy and sell shares once a day.
But with ETFs you can buy and sell your shares whenever the stock market is open
Even though an ETF is not really a stock you can buy and sell
ETFs as if they were a stock. A lot of times you'll hear the terms ETFs and index funds used interchangeably
But they're 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 Vanguard one that I mentioned earlier, or you can 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 tradeability that in ETF offers, or am I just good with an index fund?
In my experience being able to trade ETFs really doesn't help you achieve long term investing success.
Because the fact that it trades like a stock and you can watch it go up and down on a stock chart
It really only encourages impulsive buying and selling and
Human nature has a tendency towards gambling like behavior, which is obviously the opposite of smart investing.
So I personally think ETFs do more harm than good and
You know, why even deal with the added temptation?
So if you're not sure whether you should go with ETFs vs index funds then I would recommend just choosing index funds.
They're essentially the same thing, but you won't have the added temptation to gamble with your money.
Most people will only have to buy once,
Hold and then sell when they retire so you really don't need the 24/7 tradeability of an ETF.
Another reason why I like index funds and this is a huge reason actually and the reason why I switched over from
ETF to index funds is
Because index funds offer automatic
Reinvestment. This makes it really easy for you to save and invest
Without even lifting a finger. Index funds allow you to set up a recurring monthly
Deposit from your checking account and they'll automatically buy more shares for you every month.
The best part is that there's no additional charge for doing this.
This is a free automatic reinvestment feature and it makes it a no-brainer for you to automate good investing habits.
ETFs do not offer this feature if you wanted to contribute more to your investments every month.
You'd have to buy more shares of the ETF every month, which means more work for you. Of course
It means you have to pay trading commission's every time, and who wants to do that?
So I hope you have a better understanding now of mutual funds, index funds,
ETFs and what similarities and differences they have. Mutual funds came first and they offered the benefit of pooled
Investing, then index funds came along as a special type of mutual fund with much lower fees and a type of management called
Passive management, and then finally the ETF came on the scene which trades like a stock and offers everything that index funds offer except automatic
Reinvestment. For more beginner friendly info on stock investing make sure you also check out these two videos here
and
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If you have any questions at all about what I talked about in this video,
Let me know in the comments and I'll be sure to get back to you.
You can also reach out to me on Instagram at @investingwithrose. So I look forward to connecting with you there.
Always remember to go after your dreams
unapologetically and to live life on your terms!
Cheers!