40 Mutual Funds vs. Index Funds vs. ETFs

Mutual funds, index funds, and exchange-traded funds (ETFs) are all very similar investment vehicles where money is pooled from a number of investors to get shares of Companies or units in trusts.  Having these types of investments is a great way to diversity the investment risk of your portfolio, as one would be investing in hundreds and thousands of different companies all at the same time.

Think of mutual funds, index funds, and ETFs as going to the supermarket and having a basket of groceries.  Inside the basket, we can put whatever groceries that we choose.  If we want to have everything from the grocery store in the basket, it is possible.  If the investor only wants a basket with dairy products in the basket, then that is possible.  There is a basket of funds for whatever type of stocks, bonds, and other securities as well.  One can own a fund that has the entire US total stock market, or focus on a fund that is in a certain sector such as Technology.  Regional funds that have a portfolio in certain emerging market countries is also readily available.

Where these funds differ is more on how it is managed and how it is purchased.  Mutual funds are proactively managed by one or more fund managers.  These fund managers would actively review the market and make decisions to sell and purchase shares of Companies or units in Trusts on behalf of the investors.  Investors do not really have a choice on what actions the fund managers take.

Index funds, on the other hand, do not have an active fund manager.  Index funds will simply follow the benchmark index.  Index funds usually attempt to replicate a certain market.  An example of this would be an index fund that follows the United States S&P 500.  This index fund would track and monitor its portfolio similar to the shares in this index, which is the US largest 500 companies.

For exchange-traded funds (ETFs), the make-up of the investments is very similar to index funds.  Most ETFs would also simply follow a benchmark index.  The primary difference between index funds and ETFs is that ETFs, as the name suggests, is traded over a public exchange while index funds are not.  ETFs are traded throughout the day on an exchange at market prices, similar to stocks.  Index funds can only be bought and sold for a set price at the end of the trade day.  Index funds would be simpler, but wouldn’t have as much control of the price that you want to buy or sell at as ETFs on the open market.  Please note that there are also actively managed ETFs, which are traded throughout the day but have fund managers making investment decisions on the investors behalf.