Exchange-traded funds, or ETFs, mutual funds and index funds are all common investment products.
While all three of these investment funds have similarities, there are key differences between them.
One isn’t necessarily better than another, but knowing how they work and how much they cost can help you decide how to invest.
What ETFs, mutual funds and index funds have in common
ETFs, mutual funds and index funds each give you access to hundreds of stocks and bonds in a single product. Although you won’t own the individual underlying asset, you’ll own a share of the fund. This strategy is convenient as it gives you access to a diversified portfolio by purchasing a single share of an ETF, mutual fund or index fund.
All three funds are typically managed by professionals, so little effort is required on your end. All of the buying and selling of individual securities is done by the fund managers or algorithms. As an investor, choosing an individual ETF, mutual fund, or index fund can simplify the experience, something that’s particularly appealing to beginner investors.
How ETFs, mutual funds and index funds are different
Goals and style of management
ETFs and index funds typically use a passive style of investing. The fund provider uses algorithms to track an index or sector (there are some actively managed ETFs, but the vast majority are passive).
Although it’s unlikely you’ll beat the market by investing in an ETF or index fund, you’ll probably get average returns, and may eventually come out ahead.
Unlike ETFs and index funds, mutual funds have a portfolio manager who is actively trading the securities held within the fund. Their goal is to beat the average market returns for their investors.
Since ETFs and index funds mainly use algorithms, their overhead costs can be quite low and therefore so are their management expense ratios, or MERs.
Mutual funds require a portfolio manager and support staff to keep things going — which come at a cost of typically higher MERs.
In most cases, buying an ETF is easier than buying a mutual fund or index fund. That’s because ETFs are bought on an open exchange, whereas mutual funds and index funds are priced at the end of the day. You can usually buy ETFs in smaller amounts and buying them doesn’t require a special account.
ETFs vs. mutual funds
ETFs are attractive to many people since their MERs are often significantly lower than those of mutual funds.
For example, Vanguard’s Growth ETF Portfolio (VGRO) has an MER of 0.24%, whereas the MER for the RBC Select Growth Portfolio is 2.04%. While it’s not exactly an apples-to-apples comparison, the MER difference is 1.8%. Compound it over the life of your investment years, that small percentage adds up.
Mutual funds appeal to some people because of their active management. The thinking is that a higher MER is justified if the fund managers are consistently able to outperform the indexes. While there is some truth to that strategy, history has shown that passive investing often outperforms active investing, and it’s likely that trend will continue.
ETFs vs. index funds
The terms ETFs and index funds are sometimes used interchangeably, but they can mean different things. Both adopt a passive investing strategy and have lower fees compared to actively managed mutual funds. They both track a specific index or sector, such as the S&P 500 or oil and gas. And, like mutual funds, index funds are priced at the end of the day.
When purchasing index funds, however, you’ll often be required to invest a minimum amount, such as $500. On the other hand, ETFs trade like stocks, so you can buy one individual unit if you desire. That said, you may need to pay a commission fee to purchase ETFs, whereas mutual funds don’t usually charge a fee when buying or selling.
Even though index funds generally have lower MERs than mutual funds, they’re still typically higher than those of ETFs. For example, the TD U.S. Index Fund – e has an MER of 0.33%.
Index funds vs. mutual funds
The major differences between mutual funds and index funds are the management style and fees. Mutual funds are actively managed, whereas index funds use a passive approach. As a result, index funds have much lower MERs than mutual funds.
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