Plan Sponsor Series 1: What’s the Difference Between an Index Fund, an ETF and a Mutual Fund?
| This post was originally published July 15, 2015 by Lance Reising. |
| We have talked here many times about low-cost index funds, ETF's and actively managed mutual funds. But sometimes it is a good idea to step back and reexamine the basics of things from a fresh perspective. An article we read recently helped us do just that. MONEY's Ian Salisbury explains the difference between index funds, ETFs, and mutual funds in his article. Excerpts follow and the full article can be found with this link. Q: What is the difference between index funds, ETFs, and mutual funds? A: An easy way to think about it is this: Exchange-traded funds, or ETFs, are a subset of index funds; and index funds are a subset of mutual funds. "It's like a funnel," says Christine Benz, director of personal finance at fund tracker Morningstar. |
What Is a Mutual Fund?
- A basket of stocks, bonds, or other classes of assets
- Broad holdings provide diversification
- A portfolio manager picks stocks (or other assets) and actively manages them for a fee
What is an Index Fund?
- A different strategy, not stock picking by an active manager, but buy and hold.
- An index fund buys ALL the shares that make up a particular index, e.g. the S&P 500.
- Since no active management, index funds are much cheaper to operate.
- Aim is to achieve the same performance of a market, thereby earning "average performance".
"...academic research has shown that the higher expenses associated with active management and the inherent difficulty of picking winning stocks consistently over long periods of time means that most funds that aim to beat the market actually end up behind in the long run. "
What are ETF's?
- ETF's are index funds that trade on an exchange
- You must have a brokerage account to buy and sell those shares, and pay commissions (most of the time)
- They can be traded intraday, unlike regular mutual funds
- They have been one of the fastest growing segments of the mutual fund industry.
So what's the difference? There are several. Longevity is one. Traditional, actively-managed mutual funds have been the original investment vehicle since the beginning of 401(k)'s and the others have evolved over time. Investment strategy is another. As performance of traditional funds over time was measured, index funds evolved as recognition of the difficulty of beating the market became more apparent. Passive management with a buy and hold strategy is thus becoming the norm. A third is cost. Index funds, with lower costs, by definition have better net returns than actively-managed mutual funds. Many 401(k) plans today do not offer index funds at all in their investment lineup but that is slowly changing. Given the lower cost and better returns mentioned above, why not have a plan lineup which consists entirely of low-cost index funds and ETF's?