Mutual Funds, Exchange-Traded Funds, and Index Funds

Overview – Mutual Funds and Other Investment Funds

Some individuals opt not to actively manage their portfolios and may instead decide to entrust their investments to someone else.

There are several, valid reasons why a person may not want to manage their own portfolio. Perhaps they’re prone to emotional thinking, maybe they feel that they can’t dedicate enough time to manage their investments, or they don’t yet feel they currently have the skills or temperament to make investment decisions.

Whatever the reason may be, these individuals can rest easy because there are investment vehicles out there that can suit their needs.

In this article, we will go over three investment vehicles that may interest people who want to delegate their investment activities to someone else: mutual funds, exchange-traded funds, and index funds.

Mutual Funds

A mutual fund is a pool of money collected from several investors (the clients) who jointly contribute to this pool, hence the name “mutual fund”. The accumulated funds are then used by mutual fund managers to make investments in a variety of different asset classes, depending on the fund’s specific investment style and/or goals.

Assets purchased are under the management of the mutual fund. The total market value of all the assets managed by a fund is reported as a value called Assets Under Management (AUM).

Any returns generated are distributed to the clients (usually after any fund-related fees have been paid), who may choose to take the money or reinvest it back into the fund.

There exists a wide variety of mutual funds, each with a different investment style and set of investment goals.

Some focus solely on equities, some focus on fixed-income securities, whereas others may focus on specific criteria such as holding only international companies or companies with superior Environmental, Social, and Governance (ESG) ratings.

Strengths of a Mutual Fund

• A great solution for passive investors: not every investor may want to actively manage their own portfolio, and that’s fine. Mutual funds allow investors to earn a satisfactory return on their money while making very few decisions, if at all.
• Low maintenance: as long as an investor makes intermittent contributions and pays the appropriate management fees, they don’t need to take any massive action or make any major decisions.

Weaknesses of a Mutual Fund

• Superior returns are not guaranteed: just because mutual funds are run by professional fund managers does not guarantee outsized investment returns. In fact, most mutual funds fail to beat the market at all.
• Hefty fees may reduce returns: some mutual funds charge very hefty fees, which they deduct on investment returns. Returns are distributed to investors after fees have been applied, which can greatly reduce returns on a basis of net fees.

Exchange-Traded Funds

An Exchange-Traded Fund (ETF) is a marketable security that contains an assortment of different assets such as stocks and bonds.

Think of an ETF as a basket, containing several items. When an investor purchases an ETF, they are purchasing an ownership stake of that basket containing the items within.

ETFs are like mutual funds in that they are managed by fund managers and contain an assortment of different assets such as stocks and bonds, but ETFs have some key differences.

First, ETF prices fluctuate throughout the trading day. Unlike mutual funds, which can only be purchased after trading hours and are not listed on exchanges, ETFs can be purchased during active trading hours on an exchange¹.

Like mutual funds, ETFs have associated management fees. ETFs can either be actively or passively managed and therefore influence the fee of a specific ETF. Because there are so many ETF options available with varying levels of fund management, it’s not unheard of to find some with management fees that are below 1%, such as the ETFs offered by Vanguard.

Managers also offer different ETF compositions. Just like mutual funds, ETFs can take on various compositions: equities only, fixed-income only, ESG-focused, etc. The different ETF compositions are only limited by the imagination of the fund offering them.

Strengths of an Exchange-Traded Fund

• An easy form of diversification: instead of purchasing multiple individual stocks, an ETF can offer built-in diversification by holding a variety of different securities and/or asset classes. Remember, when an investor purchases an ETF, they are buying the “basket”, not every individual share.
• Lower fees than mutual funds: ETFs, for the most part, charge lower fees than mutual funds².

Weaknesses of an Exchange-Traded Fund

• Cannot choose ETF composition: although a variety of ETFs are available for investors, an investor cannot tailor an ETF’s composition according to their will. An investor’s only option is to keep searching for an ETF that eventually has a composition they like.
• Superior performance not guaranteed: just like mutual funds, an actively managed ETF does not automatically mean market-beating returns are assured.

Index Funds

Index funds are a type of mutual fund or ETF that tracks the performance of a market index.

Index funds attempt to mirror the performance of the stock market by following the composition of a certain market index. For example, an S&P 500 index fund will own shares in the companies that are listed in the S&P 500.

When investors refer to the “market”, they are likely talking about a certain index. An index fund seeks to match the performance of the stock market. Theoretically, an index fund cannot “beat” or “underperform” the market because the fund’s composition is the market.

Because index funds just follow an index, they are hardly managed, if at all. This means very low fees for people looking to buy a low-cost investment vehicle.

Strengths of an Index Fund

• Arguably the best fund for passive investors: because index funds simply attempt to mirror the performance of an index (and, by extension, the stock market as a whole), they are ideal for investors who want a true “invest and forget” type of investment.
• Can provide better returns than actively managed funds: between 2007 – 2017, Warren Buffett made a bet with mutual fund manager Tom Seides that, on a basis of net fees, an index fund would outperform an actively managed fund of funds. Mr. Buffett won the bet.

Weaknesses of an Index Fund

• Only average returns are expected: since index funds seek to mirror the performance of a market index, they will only match the performance of the broader stock market, at best. By comparison, there are some mutual funds and ETFs that manage to beat the market.

Wrapping Up

Funds are an excellent solution for investors looking to put their money to work, but don’t feel comfortable managing a portfolio themselves. Mutual funds, ETFs, and Index funds all have their own merits as well as their own demerits. However, the same can be said for actively managing your portfolio as well.

Whatever objectives an investor may have, it is important to know that funds meet the investment needs of countless individuals who seek to generate returns on their money without stressing about having to make major decisions or dedicate lots of time to managing a portfolio.

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