It’s common knowledge that investing in mutual funds, index funds, or exchange-traded funds (ETFs) can help build a diversified portfolio. These funds hold diverse baskets of securities, including stocks, bonds and other assets from real estate to derivatives. By investing your money in a variety of investments, you help minimize the risk that your investments will lose value all at once, and you broaden your opportunity for gains.
But how do you choose between these options? Each type of fund has its own advantages and drawbacks, and with planning you and your financial advisor can work to determine which is appropriate for you.
What are mutual funds?
A mutual fund pools money from many investors and uses it to invest in a variety of securities. Mutual fund shares represent partial ownership of the fund and entitle investors to the income generated by that portion. These funds tend to have minimum investment amounts between $500 and $5,000.
Mutual funds are usually actively managed. Experienced professionals select and monitor the securities held in the fund, with the aim of maximizing return while ensuring their selections meet the goals laid out in the mutual fund’s prospectus. Active management can make mutual funds a relatively expensive choice compared to other financial products. Compare fund expenses by looking at a fund’s expense ratio, which compares the funds operational expenses to the average net assets. The lower this percentage, the lower the cost associated with the fund. On the other hand, higher expenses can eat into your long-term returns.
Unlike stocks, which trade throughout the day, mutual funds only trade once per day after the market closes. Prices are based on a fund’s current net asset value (NAV), calculated by adding the total value of the fund’s holdings and subtracting its liabilities.
In addition to stock and bond funds, money market and target-date funds (TDFs) are other common mutual fund options. Money market funds invest in short-term debt. They’re designed to provide higher returns than interest-bearing bank accounts, and are used by individuals and institutional investors to invest in shares of government bonds, corporate stock, bank debt, and more. TDFs are popular retirement investment vehicles. Individuals select a TDF with a particular target date, such as the year they wish to retire, and the fund gradually shifts to a more conservative asset allocation as that date approaches.
What are ETFs?
ETFs differ from mutual funds largely in the way investors purchase them. They are traded on the stock market throughout the day just like stocks, making them a more liquid option than mutual funds. There are no minimum investment amounts, and some brokers even allow you to buy fractional shares.
ETFs are usually passively managed, built to track a broad market benchmark. Passive management doesn’t require daily human touch, which often can equate to lower costs than mutual funds. That said, some actively managed ETFs do exist, often with the goal to outperform a benchmark. Investors will likely pay more for active fund management.
What are index funds?
An index fund can be a mutual fund or an ETF, but they are passively managed and built to track a market index, such as the S&P 500 or Russell 2000, for instance. Depending on the design of the index fund it may track all or a portion of the securities in a given index. As mentioned above, passively managed funds tend to have lower costs than active alternatives.
It is not possible to invest directly in any index. The performance of an unmanaged index is not indicative of the performance of any particular investment.