By: Tanza Loudenback, Buy Side by The Wall Street Journal featuring Samantha Garcia, CFP®, AIF®, CDFA®, Wealth Advisor
A well-rounded investment portfolio should include dozens of stocks. But researching and purchasing these shares individually can be a slog. A mutual fund or ETF can do the hard work for you, and probably save you money.
A mutual fund is a basket of securities—usually stocks, bonds or a combination of both—that you can buy from an investment company or through a workplace retirement plan like a 401(k). Typically you are allowed to buy or sell once a day.
Exchange-traded funds, or ETFs, are increasingly popular investment vehicles that closely resemble mutual funds but are bought and sold a different way. ETFs are traded throughout the day on an exchange, like the stocks they own, potentially giving you more flexibility.
Both mutual funds and ETFs are overseen by a portfolio manager. Mutual-fund managers may take the traditional “active” approach of trying to pick winning stocks that will outperform the rest of the stock market, or they may take a newer “index” approach, aiming merely to match market returns. While there are also some active ETFs, most ETFs are so-called index funds that take the newer approach.
Either way, buying funds helps you avoid betting too much money on a single company. And broadly speaking, you get more bang for your buck. It’s a big reason nearly half of all U.S. households own mutual funds or ETFs. “You can really build a nicely, well-diversified portfolio using ETFs or mutual funds,” says Misty Lynch, chief executive of Sound View Financial Advisors near Boston. “They can both build wealth.”
Here is how these two popular investment funds compare when it comes to structure, trading and costs.
What is a mutual fund?
A mutual fund pools money from investors to build a portfolio of assets. Equity funds (stocks) and fixed-income funds (bonds) are the most common, but hybrid funds that contain a mixture of assets are increasingly popular.
Mutual fund shares can only be traded once a day, at the 4 p.m. market close. Most have minimum investment requirements that can range from $500 to $5,000 or more. But one fund can have hundreds of securities, giving you broad exposure to a market in exchange for a far smaller outlay that would be required to buy individual stocks or bonds.
Mutual funds are regulated by the Securities and Exchange Commission, which require each fund to publish a prospectus, which include key information about the fund, such as investment objectives, risks, performance and fees. Funds also frequently publish one- to two-page fact sheets, which include just key points. The SEC has detailed rules about how mutual funds present their fees and performance, so it’s generally safe to assume information you find in a fund’s prospectus is reliable and apples-to-apples so you can use it to compare different funds.
Mutual fund fees are crucial to pay attention to, since they directly impact your return. The fees are quoted as a percentage of your annual investment that is deducted from your balance each year. This percentage is known as an expense ratio. (If you buy a fund with the help of a financial advisor there may be other one-time fees known as loads.)
You can buy mutual funds primarily in three ways: through an investment professional at a brokerage or bank, through your workplace retirement plan and directly from a mutual-fund company.
Owning mutual funds in your retirement plan is extremely common. About eight in 10 households that own mutual funds purchased them through employer-sponsored plans, such as a 401(k) or 403(b), according to the Investment Company Institute, the fund industry trade group. This makes sense, since there are big benefits to holding mutual funds in a tax-advantaged account, but more on that later.
What is an index fund?
Before you understand what an ETF is, it helps to know about index funds, a type of mutual funds from which ETFs eventually evolved.
Historically most mutual-fund managers have aimed to buy stocks they think make winning investments. The idea is to devote time and skill to outsmarting the average investor and therefore delivering returns that outperform the rest of the market. “The fund manager is looking to get you extra value,” says Samantha Garcia, a financial planner at Halbert Hargrove in Long Beach, Calif.
The downside of this approach is that carefully researching stocks is expensive, and those costs put a drag on performance that’s difficult for most funds to overcome. Index funds take a simple approach—they aim to deliver returns for investors that match the market as a whole.
Index funds get their names from market indexes, like the Dow Jones Industrial Average or S&P 500. While the Dow is the oldest and the market benchmark that’s most frequently quoted in the media, it includes just 30 stocks. As a result, most index funds follow a broader proxy, such as the S&P 500 or Russell 3000, which respectively include the 500 and 3,000 largest stocks by market value.
Index funds basically match performance by owning one of every stock in the index. (It’s a bit more complicated, since giant companies like Apple and Exxon make up a bigger share of the indexes, and index funds buy extra holdings of these companies’ shares, but you get the idea).
Because index funds follow the lead of the market, their strategy is often referred to as “passive” investing. “You buy an index and kind of ride with it,” Garcia says.
While it might seem counterintuitive, index funds typically outperform most active funds, in large part because they are so much less expensive to operate than active funds. Most active funds simply can’t outperform the market by a wide enough margin to overcome the extra costs associated with research and trading.
According to a study by Morningstar, the investment research company, only one out of every four active funds delivered better average returns than comparable passive funds over a 10-year period.
For a long time, actively managed funds held the vast majority of investor dollars. But over the last decade, investors have begun to turn away from active funds in favor of index funds. By 2021, two of every five dollars invested in funds was held in index funds specifically—more than twice the share they held a decade earlier.