Should I Be Investing In Mutual Funds, Index Funds, or ETFs?

A common question for new long-term investors is: what is the difference between mutual funds, index funds, and ETFs?

Each has its advantages and disadvantages, which we will explore.

Today I will help you understand the difference between them and which is best for your long-term portfolio.

Quick Takeaways

• Mutual funds charge high expense ratios.
• Index funds are a low-cost way of diversifying your investments.
• ETFs are great for tracking a certain sector of the market.
• Expense ratios are fees passed on to you for managing the fund.

What Is an Investment Fund?

The main thing that all these funds share is that they are a basket of stocks. Each fund represents or holds multiple stocks within it.

This is beneficial because it allows you to own a plethora of stocks by making just one transaction.

If it were not for these funds, and you wanted to diversify your money into multiple stocks, you would have to make many different transactions and pay a lot of fees.

But, by buying a fund, you saved yourself time and money and still diversified your money into many stocks rather than just one individual stock.

1. Mutual Funds

A mutual fund is the oldest of the three. The main difference here is that a mutual fund is actively managed by a manager. This manager is responsible for adding or removing stocks from this fund.

The fund manager’s role is to outperform the market. He or she will allocate different percentages to the stocks within the fund as they see fit to beat the market.

Because of this active management, a mutual fund will have an expense ratio, typically 1–2%. The expense ratio is how much it costs the investor to invest in the fund.

Unfortunately, 1-2% may sound like a little, but it is actually a lot of fees on your part. Let's say you have a current portfolio of $10,000 made entirely of mutual funds. If the expense ratio is 2%, then you would pay $200 in fees.

Let’s say that your portfolio grows over the next 20 years to $1,000,000. 2% of that is $20,000. As you can tell, it can get pretty expensive and will add up over the years.

Over a 20-year period, you could pay hundreds of thousands of dollars in just fees.

Also, note that you have to pay the fees whether or not the fund manager is able to outperform the market. In fact, research shows that roughly 80% of fund managers are unable to outperform the market.

I should also mention that mutual funds can only be bought once throughout the day, and there is usually a minimum investment amount of $2000–3000 to get started.

2. Index Funds

An index fund is a type of mutual fund founded by John Bogle. In contrast to a mutual fund, an index fund is passively managed. The main purpose of an index fund is to track the performance of stock market indexes.

The most popular stock market index is the Standard & Poor's 500 (S&P 500). This market index tracks the stock performance of the largest 500 companies listed on exchanges in the United States.

You can buy an index fund whose job is to closely track the performance of the S&P 500.

The main benefit here is that, because index funds are passively managed, the expense ratio is relatively low. Most index funds have an expense ratio of less than 0.09%.

Vanguard has amazing low-cost index funds with ratios typically around 0.03%.

Let's say you have a current portfolio of $10,000 made entirely of index funds. If the expense ratio is 0.09%, then you would pay $9 in fees.

Let’s say that your portfolio grows over the next 20 years to $1,000,000. 0.09% of that is $900.

Do you see the massive difference in fees?

Additionally, research has shown that index funds are bound to outperform any hedge manager over a 20-year period. This is why Warren Buffet is a big fan of index funds. They are cheap, convenient, and reliable.

Just like mutual funds, index funds can only be bought once throughout the day, and there is usually a minimum investment amount of $2000–3000 to get started.

3. Exchange-Traded Funds (ETFs)

Lastly, we have ETFs. The main difference here is that ETFs can be bought throughout the day as often as you like, just as if you were buying an individual stock.

Also, with ETFs, you can always find an ETF that tracks a certain sector of the stock market. There is an ETF for everything at this point. If you want to invest in the overall technology sector, you can do that with an ETF.

There is a lot of flexibility and convenience when it comes to ETFs. The best thing is that there is no minimum investment amount to get started with ETFs.

Which is the best?

Now that you know the difference between each type of fund, only you can determine the best fund for your needs.

Personally, I really like low-cost index funds because of their reliability and low fees. It gives me peace of mind knowing that I can keep adding money and, in 10–20 years, my money will have compounded, fortunately.

But, if you do not have enough to meet the investment minimum amount, then you can stick with ETFs.

Even being in mutual funds isn’t as bad as leaving your money in your checking or savings account.

Conclusion

If you are just getting started with investing, I hope this was clarifying enough for you to determine which fund is best for your needs.

If you have already been investing for a while, I encourage you to check your investments and see how much you are paying in fees. Expense ratios can really take away a big chunk of your investment growth.

Have a wonderful week!

Muhamed

📖 Quote of the Week

Don't look for the needle in the haystack. Just buy the haystack - John Bogle