Index Funds vs Mutual Funds vs ETFs: What’s the Difference?

Investments are a key aspect of achieving a successful and secure financial future. But with the increasing accessibility of different investments, finding the right investment choice can be difficult. That’s why it’s important to explore your options and conduct research before entering into a position.

While there are numerous new and interesting investment opportunities, well-established funds still represent an excellent investment choice. In fact, one of the richest men in the world, Warren Buffett, utilized these tools to build his wealth.

But what are the primary differences between these funds, and what kind of advantages and disadvantages do they offer?

Mutual Funds

A mutual fund is a professionally managed investment fund open to investors and individuals. These funds are operated by established money managers that allocate the funds into a variety of securities such as stocks, bonds, and other assets. Mutual funds are a popular option because they offer low management fees despite being professionally managed. Fees for mutual funds tend to be around 1.5%. This is quite attractive when compared to professionally managed hedge fund fees that are typically in the double digits.

A share of a mutual fund can represent many different stocks and securities which is a simple way to diversify your investments. Unfortunately, voting rights are not passed on to the participants of the fund and instead remain with the fund manager. Mutual funds are by far the most popular investment in employer-sponsored retirement plans. This is primarily due to the low maintenance cost and the almost negligible work required to maintain the investment.

Types of Mutual Funds

The term “mutual fund” serves as an over-encompassing label for a variety of different investment funds including: equity funds, index funds, and money market funds. Mutuals funds are typically categorized by their investment type, objective, and target return rate. Equity funds are the most popular type of mutual fund, and as their name suggests, their primary investments are stocks.

Equity funds are typically established around a certain group of stocks, whether that be based on the industry of the company, the size (small, mid, large-cap), and growth opportunity/target. These funds carry different levels of risk so individuals can choose the level of exposure they are willing to take on.

These different categories of mutual funds allow investors to pick and choose where they would like to invest their money, while still harnessing the benefits of a mutual fund. Despite the many different names, mutual funds offer similar advantages and disadvantages compared to other financial instruments.

Advantages

• Low fees/expense ratios
• Instant diversification since a single share represents an entire portfolio
• Funds are divided into categories based on the type of investments they make
• Practically hands-free. Requires little to no interaction after share funds are purchased

Disadvantages

• Investors do not get any kind of voting rights
• No control over the investments or portfolio choices
• Growth tends to be slow but steady

Index Funds

Index funds are a type of mutual fund that primarily focuses on mirroring certain stock indexes. Warren Buffett touts index funds as the primary source of his wealth accumulation and has constantly promoted their use. The idea behind index funds is quite simple, money managers essentially mirror a chosen index like the S&P 500 or Russell 2000. So rather than trying to beat the market, investors can take advantage of the steady growth it has to offer.

Contrary to other funds that require research and in-depth management from their managers, index funds are relatively simple to manage. This simplicity comes from the fact that the portfolio simply consists of whatever stock is included in the target index. Because there is minimal upkeep required, fees are some of the lowest you get from a mutual fund. And since indexes like the S&P 500 have grown an average of 8% over the last several decades, index funds offer a relatively safe investment choice.

Exchange-Traded Funds (ETFs)

Exchange-traded funds or ETFs are quite similar to mutual funds as they employ similar strategies. However, they are classified as investment trusts and can be purchased and sold like common stock. The majority of ETFs are also passively managed because they tend to focus on certain stocks and market indexes. This allows for even lower expense ratios which means they offer even lower fees than mutual funds.

One of the most popular ETFs currently available is SPDR S&P 500 ETF Trust (SPY). This ETF emulates the S&P 500 which allows investors to trade based on the performance of the index. It also provides access to options, futures, and other derivatives that follow the S&P 500. All of this is possible because the ETF is traded similarly to any other stock where it can be purchased or sold during market hours and the outcome is realized immediately.

There are also a few other kinds of ETFs that offer unique advantages and disadvantages, but they are all exchange-traded securities that can be purchased and added to your portfolio.

Is there a “best” option?

Mutual funds offer a lot of great advantages when compared to other financial tools, but they can be more difficult to get into compared to ETFs. Mutual funds require investors to purchase directly from the fund, and prices aren’t realized until the end of the day. ETFs on the other hand are actively traded on the market and can be bought and sold during market hours. They are also passively managed which means that fees are much lower compared to other actively managed securities.

Both mutual funds and ETFs can be excellent investment tools to grow your money and create a better future. Each one offers its own benefits and their effectiveness entirely depends on your situation. So there really isn’t any clear winner since each one has its specific use case and can offer an advantage or disadvantage based on how it’s implemented.