What’s the Difference Between Mutual Funds, Index Funds, and ETFs?

Given their importance in appropriate investing plans, every white coat investor needs to understand the basics of mutual funds. They are, and should be, the mainstay of investing.

Mutual Funds

A mutual fund is simply a group of people banding together to invest their money. By doing so, they enjoy several benefits, including:

Professional management: The investors hire a professional management team to buy, sell, and trade securities (such as stocks and bonds) and to manage the fund. Economies of scale: The costs of running a fund, including paying the management team, are dramatically lower as a percentage of your investment when you are tens of thousands of investors instead of just one investor. Government regulation: Mutual funds are a highly regulated industry. While the first one was founded in 1924, the Investment Company Act of 1940 set out most of the rules by which they are run today. Broad diversification: Unlike hedge and other private investing funds, a mutual fund must be diversified. The minimum amount of diversification is 25% of the fund in each of two securities and 5% of the fund in each of 10 or more securities. In practice, however, nearly all mutual funds own at least 50 securities, and most own more than 100. Some own thousands of securities. Daily liquidity: Funds are also required to invest 85% of their portfolio into “liquid securities” (i.e., those that can be traded any day the market is open). In practice, most funds invest nearly all of their money into liquid securities of some type. Investors also benefit from the ability to remove all of their money from the fund on any given day the market is open, ensuring a level of liquidity nearly equal to that of a bank account for investors. Non-publicly traded investments generally do not offer this level of liquidity, and they can lock up your money for years. Ready availability: Mutual funds are available in brokerage accounts at every brokerage—in 401(k)s, 403(b)s, 457(b)s, 401(a)s, and other employer-provided retirement accounts; in solo 401(k)s, SEP-IRAs, SIMPLE IRAs, and other self-employed retirement accounts; in IRAs; in HSAs; in 529s; in ESAs; and in ABLE accounts. The government and most informed investors agree that this investment is ideal for rookie and advanced investors alike.

Management Style: Passive vs. Active

Although there is some overlap, there are two general methods of managing a mutual fund. The first is called “active management.” With this style, the fund management team is buying the securities they view as most likely to perform well and selling any securities they think are likely to do poorly in the future. They employ many different methods to try to figure out in advance which will do best.

The second method is called “passive management,” where the management team simply buys all of the securities of a certain type. Generally, this is done in proportion to some type of “index,” or list of all of the securities. For example, the S&P 500 is a list of 500 representative large US companies. An index fund designed to follow this index simply buys all of the stocks in the S&P 500 index, and the investors get whatever those stocks return.

While there was debate for many years about the merits of index fund investing, it turns out the task of the active managers is pretty difficult, especially after the costs of all that analysis and implementation (particularly in a taxable account). Long-term studies of active funds show that the vast majority will underperform a well-run index fund that's investing in the same securities. Thus, over the last two decades, index funds have become the most popular type of mutual fund. All index funds are mutual funds, but not all mutual funds are index funds.

More information here:

Managers Don’t Beat Markets (Why Index Funds Are the Best Way to Invest in the Stock Market)

10 Reasons I Invest in Index Funds

Mutual Funds vs. ETFs (Fund Type)

There are two main types of mutual funds in use today. Prior to 1990 (1993 in the US), all mutual funds were what we refer to now as “traditional mutual funds,” sometimes abbreviated TFs or MFs. Investors could buy new shares or sell their old shares at 4pm ET any day the market was open. Then, someone got the bright idea to allow investors to trade their funds all day long while the markets are open. These funds are called “Exchange Traded Funds,” or ETFs. While most long-term investors have no need whatsoever to buy and sell funds at 11:37am and 2:21pm, it turns out there are some other significant benefits to ETFs that have made them ever more popular for investors. The most significant is a large increase in tax efficiency of most ETFs when compared to most TFs.

When a TF has to sell a bunch of securities in order to give investors money back, it incurs capital gains. These must be passed on to the investors. However, the way ETFs are bought and sold allows for the fund to give a basket of highly appreciated shares of securities to an “Authorized Participant” (AP) in exchange for cash. An AP, generally a big bank like Morgan Stanley or Bank of America, is an organization with the right to create and redeem shares of an ETF by putting together the securities contained in the ETF. This creation/redemption process ensures that the Net Asset Value (NAV or price) of the ETF is always equal to the value of the underlying securities.

Most TFs are “open,” and so the value of the fund is always set equal to the value of the underlying securities at 4pm ET each market day. However, there are some “closed” TFs where this is not the case, and the fund trades at a premium or discount to the value of the underlying securities. This is generally a bad thing that the ETFs structure eliminates. Closed TFs, just like ETFs, are traded on the exchange but are not very popular due to this pricing issue.

A nice side effect of the ETF creation/redemption process is that it gives the ETF a method to flush appreciated securities out of the fund without passing capital gains on to the investors. When it is time to redeem a share, the fund simply gives the most highly appreciated shares to the AP, which can sell them without passing capital gains on to the fund investors. The AP makes money through arbitrage, and it only has to pay taxes on the arbitrage (the difference between the price of the “basket of securities” and the ETF share). Nobody pays the taxes that would have been due to the investors in a TF in a redemption scenario. Unfair? Yes, but that's the way the system works.

Vanguard patented a structure where its largest index funds have both a TF share class and an ETF share class. This has the nice effect of allowing the TF investors to have similar tax efficiency to the ETF investors. That patent has since run out, and other companies, such as DFA, are adopting the same structure to the benefit of TF investors. Thus, at Vanguard (and now DFA and perhaps others), you generally DON'T get any more tax efficiency for using an ETF instead of a TF, but that is not the case with most funds.

Most ETFs happen to be index funds. Certainly, most money in ETFs is invested in ETFs that are index funds. However, not all ETFs are index funds. All ETFs ARE a type of mutual fund although sometimes when people use the term “mutual fund,” they are referring ONLY to TFs, including both open and closed types. This non-precise use of terminology in the industry can confuse beginning investors.

Should You Invest in (Traditional) Mutual Funds or ETFs?

Most of the time, it does not matter much whether you invest in TFs or ETFs. Many investors enjoy the simplicity of not having to put buy and sell orders in on an exchange while the market is open. While it is possible to reinvest dividends with ETFs, this process is much more straightforward with a TF. Many 401(k)s, 529s, and other types of investing accounts only offer TFs. Other investors like the flexibility and tax efficiency of ETFs, particularly when investing in a taxable account.

Commissions are also often lower on ETF trades vs. mutual fund trades, particularly when buying a mutual fund at a brokerage away from where the mutual fund is managed. For example, the commission to buy a Vanguard TF or a Vanguard ETF at the Vanguard brokerage is $0 either way. However, the commission to buy a Vanguard TF at Fidelity is $49.95 while there is no commission to buy a Vanguard ETF at Fidelity. Same fund; $50 cheaper. So, many investors, like me, who prefer Vanguard funds but also invest at Fidelity or Schwab, use ETFs at those places even in tax-protected accounts like 401(k)s to reduce investing costs.

The passive vs. active issue matters much more than whether you use TFs or ETFs. The TF vs. ETF question is mostly a hassle vs. flexibility issue. Use whichever seems most convenient and inexpensive in your particular case. However, if investing in a taxable account and using funds from someone other than Vanguard or DFA, you should generally prefer ETFs.

More information here:

How Do You Evaluate and Compare Mutual Funds and Exchange Traded Funds?

The Bottom Line

Mutual funds are the broad category. They are divided into active and index funds. They are also divided into traditional mutual funds and ETFs. ETFs are becoming ever more popular due to increased flexibility and tax efficiency. However, many investors, including me, still use traditional mutual funds quite happily.

What do you think? How much of your portfolio is in ETFs vs. TFs and why? 

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