Mutual Funds vs Index Funds vs ETFs
Mutual funds, index funds, and ETFs--these are terms you will hear over and over again in the investing space. Despite their frequent use, many new investors don't really know the difference between the three.
Today I'll define mutual funds, index funds, and exchange-traded funds (ETFs), and discuss their similarities and differences.
Let's start with mutual funds and ETFs.
💡 How are they the same?
Both of these have the word "fund" in them, and that’s where the similarity lies. Both of these are pools of securities. So, what is a security? A security is defined as proof of ownership or debt that has been assigned value and may be sold. Let’s break that statement down. Proof of ownership--the simplest example of this is stocks. When you buy a stock, you are buying ownership of that company. You are buying a small percentage of Apple or Microsoft. And then there’s the debt aspect. Some good examples of debt would be CDs or government and corporate bonds. There are also hybrid securities that combine elements of ownership and debt. So, mutual funds and ETFs are pools of securities (stocks, bonds, CDs, etc).
Mutual funds and ETFs can either be actively managed or passively managed. I'll dig into the differences between actively managed funds vs passively managed funds another time. For now, just know that with actively managed funds you're paying someone to make ACTIVE decisions on the holdings of the fund. With passively managed funds, buying and selling is essentially on auto-pilot.
💡 What about index funds?
One of the most common types of passive funds is the index fund. An index fund is a FUND, so it is also a pool of securities, but this fund tracks an index. An index is an imaginary basket of securities intended to replicate an area of the market. One of the most well known indexes is the S&P 500. The S&P 500 contains the 500 largest companies in the U.S. So you can have index fund mutual funds or index fund ETFs—the main difference being how and when they can be bought and sold.
💡 How are they different?
An ETF is traded like a stock. It can be bought and sold throughout the day as long as the stock market is open. That’s why they are called EXCHANGE-traded funds--because they are sold on a stock exchange. Whereas, mutual funds are only traded at the END of the trading day. The market is open from 9:30 AM - 4:00 PM eastern time. So, if I wake up and notice that the market is crashing, even if I put in my sell order at 9:30 AM, my mutual fund will not be sold until the end of the trading day. Because of this, mutual funds are considered LESS liquid, and ETFs are considered MORE liquid.
ETFs are slightly more tax efficient than mutual funds because of a unique mechanism ETFs use for buying and selling called "creation units". I won't get into the weeds on this term, but essentially you experience fewer taxable events with ETFs than you do with mutual funds.
As far as I know, you can't automate investments or withdrawals from an ETF, but you CAN with a mutual fund.
💡 So which one?!
So, there you have it. Depending on whether you're an active trader or a long-term investor, how much you're concerned with tax efficiency, and whether you need to automate your investments, you may prefer ETFs or mutual funds. They are both excellent options for new investors, and I own both (I own mutual funds in my 403B, and ETFs everywhere else).
👀 See a visual on instagram:
📹 See it in video format:
The video also contains a list of our top 5 index funds: https://youtu.be/oM4YbclsoJQ
❓ Questions for the audience:
Which do you prefer (ETFs, mutual funds, index funds)? And do you have a favorite fund? Let me know in the comments.
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