Hands up if you ever get confused between index funds and ETFs?
I might be in the minority here, but I’ve always found this confusing. So what is the difference and which is better?
Index funds
When people talk about ‘index funds’ they are most likely talking about mutual funds.
Mutual funds are pools of money collected from lots of investors and invested in stocks, bonds and other assets.
Some mutual funds are ‘actively managed’. This means a fund manager picks stocks and other investments to try and beat the market. Active funds typically have higher fees to cover the fund management costs.
Other mutual funds are ‘passive’. This means they track an index of stocks, such as the FTSE 100 or the S&P 500. They don’t try to beat the market and instead they mirror it. Managing these funds is much cheaper and this is reflected in lower fees.
There’s lots of debate about which is better: active or passive funds. Many active funds fail to beat the market and the returns they make for investors are further reduced by expensive management fees.
This is why passively managed funds are very popular.
ETFs
ETF is short for ‘exchange traded fund’. This means the fund is actually a company, whose shares can be bought and sold on the stock market.
Just like mutual funds, ETFs can be passive or active and can invest in a similar range of assets.
So the main difference between mutual index funds and ETF index funds is…
… how you buy and sell them.
Yep. To invest in a mutual index fund I need to give my money to the fund management company and they add it to the pool of cash that is used to buy and sell the shares of companies in the index.
In effect, I own a unit or an allocation of that fund. To sell my investment and withdraw my money, the fund manager needs to sell my proportion of the shares. So there may be a delay of a day or two between my instruction to sell (and buy) and the transaction being completed.
This is fine for a long term ‘buy and hold’ man like myself, but traders want quick transactions, so ETFs are more attractive to them.
To invest in an ETF, I would buy shares in the fund (the company) directly on the stock market. Because the shares are traded on the open market, the transaction times are significantly quicker than with mutual funds.
Another factor to bear in mind, is the value of the ETF shares also fluctuate depending on the performance of the fund and other factors. Again this is probably more interesting for traders compared to long-term investors.
So what do you choose?
Unless you are concerned about completing speedy transactions, I don’t think it really matters whether you choose a mutual or an ETF. For me, the more important things to consider are low fees, market coverage (e.g. access to international stock indexes) and trustworthiness.
Thanks for reading 🙂