There is a common misconception that mutual funds,
index funds and ETFs are all the same type of
investment vehicles. And while there are similarities,
there are also some significant differences for
investors to know about. Let’s explore.
Active vs. Passive
Investors can select from two main investment
strategies: active and passive portfolio management.
Active portfolio management is exactly how it
sounds: the portfolio manager (or team) focuses on
outperforming an index by “actively” making buy/sell
decisions, adjusting asset allocation ranges and
employing other portfolio management techniques.
Passive portfolio management on the other hand
simply aims to replicate an index – not outperform
and not underperform – replicate. Therefore, there is
no portfolio manager making buy/sell decisions.
Mutual funds are either active or passive – if passive,
then they are called index funds. ETFs can also be
considered either passive or active.
Mutual Funds vs. Index Funds vs. ETFs
An active mutual fund is a diversified1 basket of
securities that is professionally managed (hence the
“active” term) using a combination of stocks, bonds,
and cash. Mutual funds are priced at the end of every
trading day – once the markets close at 4 PM EST.
Index funds are designed to track a specific index, like
the S&P 500 Index or Russell 2000 Index and since
they are technically mutual funds, they are also priced
once a day when the markets close. But since index
funds are not actively managed, generally speaking,
they will offer lower costs to shareholders, relative to
actively-managed mutual funds.
ETFs, like index funds, are also designed to track a
specific index. But unlike mutual funds – including
index funds – ETFs can be traded throughout the day
like a stock.
Fees Are Different and Complicated
Before we discuss the differences in fees, it’s
important to remember that there are almost 10,000
different mutual funds, index funds and ETFs, so it’s
impossible to speak in absolutes.
That being said, fees for index funds and ETFs are
generally lower when compared to mutual funds. In
fact, the Investment Company Institute reports in
2017 the following:
Mutual fund expenses – the average expense
ratio of actively managed equity mutual funds
fell to 0.78%, from 0.82% in 2016, and the
average expense ratio for actively managed
bond mutual funds fell to 0.55%, from 0.58%.
Index funds expenses – over the same period,
the average expense ratios for index equity
mutual funds and for index bond mutual funds
remained unchanged at 0.09% and 0.07%,
ETF expenses – in 2017, the average
expense ratio of index equity ETFs fell to
0.21%, down from 0.22% in 2016, and the
average bond ETF expense ratio was 0.18%
in 2017, down from 0.20% in 2016.
Many mutual funds charge sales commissions
– as high as 5.75% for Class A shares. In
addition, mutual funds might charge
transaction fees of $10 or $75 per trade – both
really depend on the mutual fund and how
Index funds don’t charge sales commissions
but might have similar mutual fund
transactional fees. Again, it depends on the
fund and how you’re buying
ETFs, on the other hand, since they are
traded throughout the day just like a common
stock on a stock exchange, charge fees every
time you make a trade (buying and selling).
These fees are generally around $5-$10 per
trade, so for low dollar amounts or high-frequency
trading, the commissions on ETFs
can really add up.
So, which are better?
Truthfully, mutual funds, index funds and ETFs have their upsides and downsides, depending on an investor’s needs. All three are fantastic tools, if used properly. And they are all excellent tools allowing you diversification at a low price.
In a nutshell, a lot depends on how much you are investing right now, how often you will trade and what amount of flexibility is needed.
Sound confusing? Well, that’s why your financial advisor can help navigate the differences and recommend the appropriate investment vehicles for you and your family.
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Diversification does not ensure against loss.
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