index fund vs etf vs mutual fund

Index Fund vs ETF vs Mutual Fund

Basic Investment Options

Investment options are seemingly endless.  There are stocks, mutual funds, CDs, Index Funds, ETFs, money markets, bonds, etc. But in this article let’s discuss the differences between an index fund vs ETF vs mutual funds.

Let’s face it, most of us are researching this topic because to put it no easy way; We Are Rookies.  Don’t be afraid of not knowing, the easiest way to start investing with limited knowledge is to simplify your choices.

The Big Three

Index Funds, Mutual Funds, and ETFs are going to be a great option for a beginner or even a seasoned investor.  They allow you the most simple investment options with a relatively small amount of prior research or knowledge. 

These types of investments focus on larger groups of stocks and bonds instead of trying to pick individual winners. 

Why is fund investing a good strategy? 

Historically the average stock market return on investment is somewhere around 7-8% after accounting for inflation.  That means a $6000 investment each year could leave you with almost $1,679,000 after 40 years.  Not too shabby for an amateur investor. 

Index Funds:

Index Funds are a group of stocks, bonds, or securities that represent a specific stock market index. An index is just another name for a chosen group of assets.  There are many different indexes that can be followed, but one of the most popular is an S&P 500 Index Fund. 

The S&P 500 Index tracks a group of 500 US companies meeting certain criteria that tends to make up a good representation of the United States’ economy.  This type of fund gives an investor a well-diversified portfolio by simply purchasing one fund.  Index funds can be bought directly through an investment company or brokerage firm.

Index funds are endless, there are some available tracking Large Cap companies, Foreign markets, high dividend stocks, and everything in-between.  Researching and sticking to some of the more basic funds are a great starting point.

Because Index funds simply track a group of companies that make up that group, there are typically very low fees associated with it. Index funds are more passive investments because there is no behind-the-scenes shuffling by a fund manager who is trying to get you the best returns.

A fund’s expense ratio is the cost an investor must pay to own that fund. Because it doesn’t take many resources in creating and managing an index fund the associated costs of owning them are minimal. 

Index Funds are going to get you average market returns over time, but average returns are nothing to be ashamed of.

Exchange-Traded Funds or ETFs:

ETFs are becoming a more popular method for everyday investors.  Exchange-Traded Funds often track indices similar to traditional market index funds and are passively managed.

While mutual funds are normally bought directly through the investment company, an ETF is bought and sold through a broker similar to an everyday stock purchase.  ETFs often have some of the lowest expense ratios available.  However, just as stocks have trading commission fees, so do ETFs.  

Each time you buy or sell an ETF, you will pay the flat-fee commission price to your broker.  Fortunately, a lot of brokers are offering commission-free ETF selections to make them more attractive to clients.  For the investor who is buying and selling with small sums of money, ETF trading commissions can really end up costing you over time.

ETFs do have some advantages over mutual and index funds.  First, their expense ratios or cost of owning the fund over a period of time is normally significantly lower than mutual funds.  Mutual funds and index funds can only be traded once per day based on the fund’s closing price.  ETFs allow intraday trading much like individual stocks, giving the investor more flexibility to get in at specific prices.  As ETFs are expanding there are options that follow almost all niche sectors of the stock market.  

Mutual Funds:

Mutual Funds on the other hand are made up of investments hand-picked by a fund manager. 

A fund manager generally has a research team that tries to round up the best stocks, bonds, or assets which will yield the highest returns for the fund.  A lot of time, money, and research goes into these funds which is the main reason why you will see a higher expense ratio as compared to an index fund.

Mutual Funds can be chosen just like index funds to track specific sectors of the market or a blend of the manager’s choice.

They can be chosen with high risk, giving the potential of big returns, but also big losses. And on the other hand, they can be chosen with low risk potentially avoiding large losses, but also most likely limiting your chances of high returns. 

A traditional example of a low-risk portfolio would be a largely bond-weighted fund. An example of a high-risk portfolio would be largely stock-based mutual fund.

The appealing idea behind a mutual fund is that a well-experienced financial expert is choosing and actively managing the make-up of the fund. Theoretically, your chances of beating average market returns can be higher.  However as history has shown, the theory does not always prevail. Many mutual funds have trouble consistently beating index fund returns.

Summary:

Index funds are an investment group that is passively managed to track a specific stock market index. They have low-cost ownership and one can expect average returns.

A mutual fund is an investment group that is actively managed. Mutual funds are made up of the fund manager’s choice investments based on their research and data. Returns can vary greatly, but funds can be low or high-risk tolerance driven. Mutual funds typically have a higher cost of ownership than index funds or ETFs.

ETFs are investment groups that are passively managed and can track a wide range of assets just like the previous two. The big difference between ETFs is that they can be traded intraday similar to individual stocks. ETFs typically have the lowest cost of ownership of the three. Returns vary greatly dependent upon the investment mix.

Do some research as to what investment strategy fits your financial situation best?  An index fund, ETF, or mutual fund can all be great options.

The only mistake you can make is not investing.  Those trying to time will most likely lose out on potential gains.  Remember that the majority of your investments should be for the long haul.  History is on your side for making average gains over long periods of time!

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