When you are new to investing, terms like “Mutual Funds”, “Index Funds”, and “ETFs” can be confusing. You hear them a lot, they sound important, and you may feel like you are on the outside looking in. The goal of this post is to clarify what each of these is and clarify how they might apply to you as an investor.
When I was a kid, it seemed like I couldn’t walk three steps without tripping over the term “mutual fund.”
“Mutual fund this…” and “mutual fund that” my father was always professing to anyone willing to lend an ear.
I was unwilling.
Nevertheless, one byproduct of absorbing this term repeatedly throughout the years was that it took on an almost mythical aura. It seemed like a secret world, that to access, you needed some magical password or key.
“Mutual funds must unlock the answers to all of the world’s problems,” I probably mused.
You get the idea. They seemed like a really big deal that were out of my reach.
The truth of the matter is that they are really quite simple to understand. And once you understand what they are, it might demystify this whole process of investing a little bit as well.
The same can be said for index funds and ETFs. Once you understand the general concept, they can become far less intimidating.
So let’s have a look at mutual funds, index funds and ETFs. If, at the end, you still have questions, then throw them my way in the comments and I’ll happily look into it for you (that offer stands for any questions you have btw).
What Exactly is a Mutual Fund?
To understand mutual funds, it helps to have a grasp on the concept of a stock.
A stock is basically a very small piece of a company that you can buy and own. Essentially, when you buy a stock you become a part-owner of that company. An owner that has no say in anything at all, but an owner nonetheless.
Buying a stock is like saying, “I like the direction of your company and I want in!”
And for our purposes, you can only buy stock in companies that are “publicly traded”. This means that they are available for purchase by anyone in the stock market.
So, once you have this understanding, then figuring out mutual funds becomes a little less complex.
A mutual fund, for our purposes, is simply a collection of stocks assembled together in one group (or fund).
To be fair, mutual funds can also have bonds, or other assets as well, in addition to stocks…
But really, if you think of a bucket, and you fill it with a bunch of different stocks, and perhaps some bonds or other assets, whatever is in that bucket, is the mutual fund.
Then, when you purchase that mutual fund for your own portfolio, you are buying small chunks of everything that is in that bucket in one simple purchase.
Part of the allure is that the mutual fund takes all the work and research out of it for you. You have a team of investors putting together this perfect blend (or bucket) of stocks that you can buy in one neat little package.
Who Decides What Goes in the Bucket?
Usually, an investment firm, will have a team of investors that collaborate on an individual mutual fund.
For this, I think of it like they are trying to make an award winning chili (for example). If they get all the ingredients just right, then this chili will be irresistible. The judges will take note, the people will want the chili, it will garner huge accolades and the chili will thrive.
Applying this to a mutual fund, the fund managers, are trying to assemble a wonderful collection of assets in this one pot so that the fund thrives and the people buy it.
As the market fluctuates, these managers can add or subtract assets in their mutual fund, with the idea being that they are constantly positioning the fund to succeed, making it more enticing to investors.
How Expensive are these Mutual Funds?
When you purchase a mutual fund, the investment firm you bought it from is able to collect a small fee known as the expense ratio. If many people buy this fund, then they get many small fees which add up to large profits for the investment firm.
Expense ratios can vary from fund to fund. They can be as low as 0% and can be seen as high as 2% (or even higher). While 2% doesn’t sound like much, it can be the difference of hundreds of thousands of dollars over many years.
To illustrate the significance of these expense ratios I have copied and pasted a table I made from my “Investing Basics Made Very Simple” (link below in next paragraph) post. In the table you will see how much a fund costs over 30 years, investing $10,000 per year at an 8% rate of return.
| Expense Ratio | Cost of Expense Ratio |
|---|---|
| .05% | $13, 114 |
| .25% | $64,178 |
| .5% | $124,992 |
| 1% | $237,232 |
| 1.5% | $338,049 |
| 2% | $438,633 |
As you can see, those high expense ratios add up to massive amounts over time. This is all money you could be keeping for yourself (for the most part)!
For this reason, I’m on board with the advice I read about from people I respect. For my money, I’m investing in mutual funds with very low fees. If you’re interested, here is a post called Investing Basics Made Simple, that goes into the details on how I choose to invest my money.
So, what are these low-fee mutual funds that I speak of? Well, for starters, they are usually not actively managed funds like the ones described above. Investment managers cost money and I’m sure their pay is not cheap. These fund managers are in charge of cooking up this perfect recipe of funds and constantly adjusting it to move with the fluctuating market. All of this costs money and it usually comes at an expense to the investor in the form of an expense ratio.
So, for my money, I try to avoid those fees by investing in index funds.
What’s An Index Fund?
For starters, an index fund is a type of mutual fund.
But, an index fund is automated rather than actively managed. It is designed to “follow” a particular “index”.
An example of an index is the S&P 500 index. For the most part these are the top 500 publicly traded companies in the country (Amazon, Google, Facebook (Now Meta) and so on.).
An S&P 500 index fund would simply have all 500 of the stocks in the S&P 500.
As you can see, there is no real thinking or “managing” involved. If a company drops out of the top 500 the fund sells it and buys the new one that took its place. Simple. Automated. Clean. Inexpensive.
And because this S&P 500 index fund doesn’t have those expensive human fund managers, it keeps the costs very low (much, much closer to 0%).
In addition, index funds typically outperform somewhere near 80 – 90% of all actively managed funds.
The end result is that it’s far less expensive AND it’s much more likely to do well. Sign me up for that!
Their are plenty of other index funds out there that track various indexes (indices? ). Some do better than others, but for the most part, all of them have very low fees.
Personally, based on the advice found in the Financial Indepence community, I gravitate to “total market index funds.” These funds buy EVERY publicly traded company in the United States. So, in essence, by buying these funds I am owning an infinitesimally small portion of every publicly traded US company.
I’m also indirectly betting on the US economy. This is a good bet according to Warren Buffet. Who am I to argue?
If you are interested, I wrote a post on 3 total market index funds, that I bought on the exact same day so I could compare them to one another in a horse race of sorts. It is aptly named Total Market Index Fund Horse Race. I found the results to be interesting and I hope you agree!
Also, FYI, Vanguard is widely considered to be the best index fund company in the game. And rightfully so! Their founder, Jack Bogle, invented the darn things with the idea that the individual investor should thrive in lieu of the investment firm.
I have an account with Vanguard and plan to open a 403b with them when I get back to work.
So now that we know that an index fund is essentially an inexpensive mutual fund run by a computer instead of a team of humans, let’s figure out what the heck this ETF thing is!
What’s an ETF?
My best explanation of an ETF (Exchange Traded Fund) is this:
An ETF is an index fund that is sold like a stock.
Basically, when you buy or sell mutual funds (a group which includes index funds) you do so after the market has closed for the day. If the market were to surge up until noon and then plummet down until its close at 4pm EST, it would NOT really matter when you clicked “buy” during that very tumultuous day.
You would just buy the fund at the price it was at closing (at 4pm EST).
But, for an ETF, that huge fluctuation would matter! For an ETF you are purchasing that fund at the specific time you click “buy”. So if you buy after the market dips down, and then it suddenly surges up, you’ve already made a little money that day! The reverse is also true. This is similar to how stocks are bought and sold.
Like a typical mutual fund, it is still a collection, or bucket, of assets.
Unlike a typical mutual fund it can be bought instantly and is instantly at the mercy of whatever the market does for the rest of that day and beyond.
Personally, I don’t have a lot of ETFS. I’m a long term investor so I don’t anticipate having the need to buy or sell from one minute to the next. I just set it and forget it.
That’s not to say there is anything wrong with them. If chosen correctly, they are a perfectly fine investment. For example, VTSAX, which is Vanguards “total market index fund” also has an ETF equivalent called VTI.
These are, by my eyes, and from what I’ve read, the exact same thing. They are both total market index funds. VTI, however, can be bought and sold like a stock.
I also see, that VTI has an ever-so-slightly lower expense ratio (.03% vs .04%). So, by those metrics, VTI might be the slightly better option (by the thinnest of margins). Remember, I am not a financial expert in any way shape or form! I am but a humble teacher. Humble like a fox! (That makes no sense.)
But realistically, for the long term investor, if one of these total market index funds is of interest to you, then either is probably a fine choice.
In Summary
So there you have it! There’s your explanation for mutual funds, index funds and ETFs.
A mutual fund is a bucket filled with many assets, including stocks, bonds and more, that are grouped together and sold as one fund.
Many of these are actively managed and have higher expense ratios associated with them.
Index funds, on the other hand, are still mutual funds but are not actively managed. They are automated and set to follow a specific index in the market (like the S&P 500 index). Because they are passively managed, they have much lower expense ratios.
They also outperform between 80% and 90% of actively managed mutual funds.
Meanwhile, an ETF (Exchange Traded Fund) is like an index fund that can be bought and sold like a stock. In general, the expenses for these appear to be slightly lower than the equivalent index fund.
For my money, I choose to follow the advice of many in the Financial Independence Community (Here’s a post I wrote on the FIRE (Financial Independence Retire Early) movement and its profound impact on me) and I buy low-fee index funds and ETFs like VTSAX or VTI.
Finally, if you are interested in a way to dabble in the investing world to see if it’s a fit for you without putting too much on the line (it could be as low as $1), here’s a post I wrote called the Dip Your Toes Investing Strategy for Beginners.
That’s all for now! I hope that was a helpful clarification of mutual funds, index funds, and ETFs and that it demystified it for you a bit as well. If you have any questions on this or anything else that you want me to look into, don’t hesitate to ask below in the comments or contact me any time!
0 Comments
1 Pingback