ETFs, Index Funds and Mutual Funds are common types of investment vehicles that pool investor money to buy diversified portfolios of assets. Each differs in structure, management and trading methods. A financial advisor may be able to help you choose the right investments for your goals. Here’s a breakdown of the key differences.
What Are ETFs?
Exchange-traded funds (ETFs) are investment funds traded on stock exchanges, much like individual stocks. The concept of ETFs was introduced in the early 1990s as a blend of mutual funds and individual stocks. Prominent ETFs today include SPDR S&P 500 ETF (SPY), Invesco QQQ Trust (QQQ) and Vanguard Total Stock Market ETF (VTI). Some key features of ETFs include:
- Traded like stocks
- High liquidity
- Lower expense ratios
- High tax efficiency
What Are Index Funds?
Index Funds are types of mutual funds or ETFs that aim to replicate the performance of a specific index. The first Index Fund, Vanguard 500 Index Fund, was created in the 1970s by John Bogle, the founder of the Vanguard Group. Today, popular Index Funds include the Vanguard 500 Index Fund (VFIAX) and Fidelity ZERO Total Market Index Fund (FZROX). Some key features of Index Funds include:
- Track specific indexes
- Passive management
- Lower cost
- Diversification of portfolio
What Are Mutual Funds?
Mutual Funds are perhaps the most well-known type of investment fund. Established in 1924, the first modern mutual fund, the Massachusetts Investors Trust, offered investors the opportunity to pool their money to achieve diversification and professional management. Notable Mutual Funds today include T. Rowe Price Equity Income Fund (PRFDX) and Vanguard Total Bond Market Index Fund (VBTLX). Some common features of mutual funds include:
- Professional management
- Tend to be actively managed
- Convenience
- Diversification of portfolio
Differences Between ETFs, Index Funds and Mutual Funds
ETFs, Index Funds and Mutual Funds pool investor money to buy a diversified portfolio of assets. However, each differs significantly in structure, management style and trading characteristics.
One key distinction is how they are traded. ETFs can be traded like stocks, picked up or dropped at any time during trading hours. Mutual funds, however, can only be purchased at the end of the market day.
Index funds, on the other hand, are a type of mutual fund or ETF. And as such, get traded and settled according to its structure, whether that is a mutual fund or ETF. So an index ETF purchase order wouldn’t execute at the end of day net asset value (NAV) like an index mutual fund.
Another consideration, and a major difference, is the total cost of investing in each. ETFs and index funds tend to have lower expense ratios, which lowers the total cost when compared with actively managed professional mutual funds. It is something that should be factored into the total return as you’ll be paying less of that return to a firm.
Bottom Line
ETFs, Index Funds and Mutual Funds each offer unique advantages and potential drawbacks. The best choice will depend on your financial goals, risk tolerance and investment strategy. Precisely for this reason, a financial advisor can be of immense help, guiding you to decide which investment option is best for you. By understanding the differences between these types of funds and taking professional advice before investing, you are more likely to make more successful investment outcomes.
Tips for Investing
- Choosing the right type of investment for your situation can be difficult, especially if you’re not experienced in the market. A financial advisor can offer expertise to help you match the right investment choices to your long-term financial goals. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- You can use an investment calculator to help you estimate potential returns, based on the assets you choose in your portfolio, over a specific period of time.
Photo credit: ©iStock.com/sturti, ©iStock.com/Vladimir Vladimirov, ©iStock.com/vitapix