Index funds, exchange-traded funds (also known as ETFs), and mutual funds are similar investment products. By doing one transaction, you’re able to own a small percentage of all its underlying assets.
Instead of purchasing a single stock, or individually purchasing multiple different stocks, you can purchase one index that gives you access to a group of assets in one transaction. Technically, you don’t actually own each individual asset in the group, but you own a share of the fund that holds all of the assets. Each fund could include tens, hundreds, or even thousands of individual assets, providing you a simple way to diversify your portfolio. If a single stock in a fund swings wildly from day to day, it can have little impact on the overall performance of the fund.
For example, the S&P 500 is a well-known major index, made up of the 500 largest companies publicly traded on the stock market. By purchasing one share of the S&P 500, you’re immediately exposed to all 500 stocks.
The main difference between mutual funds, index funds, and ETFs
All three types of investment funds work in a similar way – you purchase a share of the fund that gives you exposure to all of its underlying assets. The main differences between them are how they’re managed and what you’re able to do with them.
Investment style and goals
Mutual funds are different than index funds and ETFs in that they’re actively managed by an human investment professional. And because they’re actively managed, the goal isn’t just to match the market, but to beat the market. Comparatively, index funds and ETFs take on a passive investment strategy using algorithms and the goal is to match the market rather than to beat the market.
In the long run, index funds and ETFs typically outperform most actively managed mutual funds. Strong mutual fund managers can beat the market in some years, but it’s difficult for active managers to consistently beat the market.
Mutual funds, ETFs, and index funds all charge investors fees called an “expense ratio” for managing the fund. This is an annual fund operating expense used to compensate the fund for managing your portfolio.
Because a mutual fund is actively managed by a human investor and aims to outperform the market, fees are significantly higher than for passively invested ETFs and index funds. The average expense ratio for actively managed mutual funds is between 0.5% and 2.0%. A 2% fee might sound small on paper, but that’s a $20,000 per year fee with $1,000,000 invested. Comparatively, index funds and ETFs can have expense ratios as low as 0.05%.
The downside of a mutual fund is that you still need to pay the fees even if the fund loses money.
Minimum purchase requirements
Most actively managed mutual funds have minimum purchase requirements, usually several thousand dollars. While most index funds do not have a minimum purchase requirement, many may require at least $500 to $5,000 to get started. ETFs, on the other hand, don’t have any minimum purchase requirements but you do need enough money to purchase at least a single share of the ETF.
Index funds vs ETFs
Index funds and ETFs are similar in nature. They’re both passively managed, meaning that their goal is to match the market, not beat the market. They both track a specific index (ex. S&P 500) or a sector (ex. oil and gas).
Because there is no human investor actively trying to beat the market, fees are typically low. However, you may encounter minimum purchase requirements with an index fund (usually between $500 to $5,000), while an ETF only requires that you have enough money to purchase a single share.
Two major differences
There are two major differences between index funds and ETFs, and they could be the deciding factor in which one you invest in.
- Trading: Index funds are purchased directly from a fund manager and can only be traded once per day, priced at the end of the trading day. For example, if you place an order to sell shares of an index fund in the morning, the transaction won’t take place until the market close at the end of the day. ETFs, on the other hand, are traded on an exchange and can be bought and sold like stocks whenever the stock market is open. If you’re a long-term investor and don’t plan on making frequent trades, index funds could be the better option since the ability to buy and sell can encourage impulse trading when the market becomes volatile.
- Automatic dividend reinvesting: Index funds offer automatic reinvestment, while ETFs do not. When you earn dividends from an index fund, they can be automatically reinvested with zero fees to buy more shares in the fund. When you earn dividend payments from an ETF, you’ll have to buy more shares manually and may have to pay trading commissions every time.
Index funds vs mutual funds
The goal of an index fund is to match the investment returns of the index, while a mutual fund tries to beat the returns of an index.
While index funds and mutual funds invest in similar assets, index funds invest in a specific list of securities while actively managed mutual funds can continuously change their list of investments, chosen by a human investment manager.
In other words, index funds invest in a specific index. If a stock is in an index, it will be included in the fund. On the other hand, a mutual fund manager actively picks the stocks and securities in their fund in order to try and beat the market.
Because mutual funds are actively managed by a human investor, the performance of the fund is dependant on the investment decisions of the humans managing the fund. With an index fund, the performance is simply based on the price movements of the assets in the fund.
Mutual funds have higher fees because the manager needs to be compensated for their efforts in picking out the best assets to beat the market.
Which one should you choose?
Index funds are usually the preferred choice for most people looking to just put money into the stock market as a passive, long-term investment strategy. While returns may differ each year, the average stock market return is about 10% per year when measuring by the S&P 500 index. Index funds have lower fees than mutual funds (since you’re not paying a human investor to try and beat the market) and offer automatic reinvesting of dividend payouts.
ETFs are similar to index funds, but offer slightly more options if you want to be more active with your investing. While you can only trade index funds once per day, ETFs can be bought and sold like stocks whenever the market is open. However, if you plan on investing for the long-term, without doing much buying and selling, index funds can be a more convenient option since ETFs do not offer automatic reinvestment of dividends.
Mutual funds involve a human investment manager to choose the assets in their fund to try and beat the market. Because it’s actively managed, fees can be much higher with mutual funds and they’ll usually have higher minimum purchase requirements to get started. While the idea of beating the market is alluring, most mutual funds underperform against index funds and ETFs in the long run. While it’s possible to beat the market some years, it’s difficult to consistently beat the market every single year. And if the fund loses money, you still need to pay the higher fees.