Mutual Funds, Index Funds & ETFs | What’s the Difference?

A Beginner’s Guide to Investment Funds

You have some money, and you know you should invest it, but you have no idea where to start. You’re vaguely familiar with investment funds, but you can’t seem to decipher the difference between fund one, two and three. So let’s start at the basics of some of the most popular options – mutual funds, index funds and exchange-trade funds (ETFs).

What is a Mutual Fund?

This is a type of investment fund that pools together money from different investors like you and then purchases a variety of securities with that pool of financing. As mutual funds are heavily managed by professionals, they advertise a return higher than the market to the investor. These funds trade only once daily, as at the end of each trade day, the net asset value (NAV) of the combination of securities in that fund is calculated. The investors of these funds can be quite hands-off. However, the total fees associated are typically higher for mutual funds due to the active management involved.

What is an Index Fund?

As time went on, the hidden fees associated with mutual funds were getting a little out of hand, and so they evolved to create index funds. An index fund is an investment fund that is not as heavily managed as mutual funds, and it imitates the performance of an existing “category” or index. This index is typically a well-known and respected index such as the S&P 500, which are five-hundred big companies that are in the marketplace. The fund will hold the securities in similar proportions to what is found in this actual index. When compared to a mutual fund, the costs associated with an index fund are lower due to reduced active management. However, similar to mutual funds, they can only be traded once a day.

What is an Exchange-Traded Fund (ETF)?

An ETF is an investment method that combines the diversification of assets that the above two funds allow, with the ease of stock trading.  It is traded on the stock market, but instead of investing in a particular stock, you are investing in a basket of different assets such as stocks, commodities, bonds, which are all pooled together. Once again, as active management is not involved, the combined costs tend to be low for ETFs when compared to mutual funds. As ETFs act like stocks, they can be traded intraday.

Where should you put your money?

Here, I urge you not to listen to me, a strange voice on the internet. Instead, I share with you the words of one of the world’s most successful investors, Warren Buffet. In 2008, Warren Buffet made a bet that in 10 years, “the S&P 500 [would] outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs and expenses.”

The business magnate reminds us of this in his 2017 letter to investors. Essentially, what he is saying in the letter is that he only knows of probably ten fund managers that can beat the market. Most likely, the majority of the populace will not be putting their money where these fund managers work. Thus, this self-made billionaire places his bet that the S&P 500 will outperform hedge funds when looking at the investor’s gains post fees, costs and expenses. When paying for expertise of fund managers, our gains will most likely be reduced to average or below by the fees we have to pay back to the experts. Therefore, the novice investor is much better off by investing in an unmanaged low-cost index fund.

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