This article is here to address all of the (asides) that I’ve promised to explain in previous writings but have yet to execute. I’m big on an aside (if you haven’t already noticed).
“When I stepped out into the bright sunlight from the darkness of the movie house, I had only two things on my mind: Paul Newman and the difference between mutual funds, index funds and ETFs.” (It pains me to clarify that this is a rephrase of the introductory sentence of S.E. Hinton’s coming-of-age novel The Outsiders since my editor did not discern it).
So, my brilliant novice investors, whether you go to open an account with a full service broker, a robo-advisor or a discount brokerage, you’ll notice these ‘fundy’ words floating around: mutual funds, index funds and exchange-traded funds. As with everything in this industry, (sigh), they are sort of similar but also different and just confusing enough to warrant this article, and, as per, my unsolicited advice on my personal favourites.
1. Mutual Funds.
Think of a mutual fund as the Model T (I’m trying to expand my referencing here so bear with me, cars are not my forte). It came first and was groundbreaking in its day, but its worth in today’s society dulls in comparison to current, more efficient cars. The mutual fund was created as a way for people to pool their money and make investments together (adorable). In fact, a Dutch merchant who created one of the first mutual funds in 1774 named it “Eendragt Maakt Magt”, which translates into “unity creates strength” (more adorable – pull that one out at your next (outdoor socially distant) house party).
The mutual fund allows the investor to own a bunch of stocks while only making one purchase (that of the mutual fund). If you wanted to have 50 stocks in your portfolio, you would have to make 50 separate purchases and pay trading commissions 50 separate times and, really, I can think of 50 more desirable ways to spend your time. Mutual funds are also beneficial as they offer diversification, an investment strategy that reduces your investing risk by holding a variety of assets (a “don’t put all of your eggs in one basket” type matter). I made a reaching vegetable/lettuce metaphor a month back about diversification that you can read as a refresher if you’re so inclined. Essentially, mutual funds bank on not every industry crashing at the same time – a reasonable assumption.
Mutual funds are professionally managed for an annual fee of 1-2% of your account balance. This is where my stubborn Taurus energy grows disinterested (I am aware I’ve just effectively lost 90% of my readers by exposing my interest in zodiac signs on a finance site, but I liked the reference, it felt very “I Don’t Need A Man” by the Pussycat Dolls).
But don’t take it from my stubbornness and Nicole Scherzinger, I understand we may not be the most reliable of sources. Look at the simple math:
If you invest $10,000 into a mutual fund = $200 goes into the fund managers pocket.
If the manager makes poor investment decisions and your account balance goes down, you still get charged 2%, leaving you with less money than when you started. All in all, Nicole and I vote that mutual funds are relatively outdated and not worth the high fees.
2. Index Funds.
This is our Prius (I’m biased because this is what I drive). Revolutionary, made for our modern-day needs and easy to use. The index fund was created by Jack Bogle in 1970 to bypass the high management fees of mutual funds. It is passively managed as it follows a fixed formula, eliminating the need to make buying and selling decisions and reducing the expenses passed on to the investor. An index (as we’ve learned! Look at us building blocks) is a representative sample of the stock market, like the S&P 500 or Dow Jones. An index fund simply allows you to invest in the stock market as a whole, which has proven to have annual average returns of about 7.96%. The passive management results in fees of around 0.04% so, again with the math:
If you invest $10,000 into an index fund = $40 goes towards fees.
Think of index funds as ballet, and mutual funds as dance, as noted in the not-at-all famous antimetaboles: all ballet is considered dance but not all dance is considered ballet. That is, all index funds are mutual funds, but not all mutual funds are index funds. The index fund has all of the convenience and diversification of the mutual fund, without the high fees and active management. In many cases, index funds outperform actively managed mutual funds since the active management needs to outperform the market and the fees.
Another plus of the index fund (and mutual funds as well) for my most fiscally responsible reader, is that they allow for an automatic-purchase plan. This means you can set up a recurring monthly deposit from your checking account and automatically buy more shares at no additional charge. It is like force-feeding good saving habits, which some of us, (yours truly), could benefit from. Nicole and I are quite obsessed with this option for the young investor who has no time to spare on trading.
3. Exchange-Traded Funds (ETFs).
Some other hybrid car? Made 15 years after the Prius? This metaphor has unravelled, I never should’ve gone with cars (comment below the right reference so long as it’s not a Tesla – I’m writing a whole thing on them and they don’t deserve a comparison to ETFs). Whatever is similar to a Prius but takes more consistent upkeep (that is not a Tesla), is our ETF. An ETF tends to be used interchangeably (and mistakenly) with an index fund because they only have one major difference. The investor can buy and sell shares of an ETF whenever the stock market is open, operating similarly to any other publically traded stock. An index fund only allows the investor to buy and sell shares once a day.
To decide between these two, you must ask yourself if you need 24/7 tradability.
If you’re going for a Wall Street moment, I applaud you, the ETF is the way to go.
If you’re a novice, such as myself, and haven’t the time for daily trading and the focus therein, go for the index fund. The ETF also fails to offer the automatic-purchasing of index funds and mutual funds, and consistent trading will result in trading fees (hence the ETF being a Prius, but newer and requiring more work). With this said, ETFs are also an ideal place for beginner investors due to their range of investment choices, diversification and low expenses, so this too, is a smart investment choice.
In following the beautiful cyclicality of The Outsiders, and, moreover, grasping at any opportunity to make my adolescent education seem worthwhile (since cursive writing and the Pythagorean theorem have yet to pull through), I will end as I began.
“When I stepped out into the bright sunlight from the darkness of the movie house, I had only two things on my mind: Paul Newman and financial literacy.
Until my next, inevitably late article submission…
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