MUTUAL FUNDS vs INDEX FUNDS vs ETFs

There are literally thousands of funds available to investors today.  There are various ways that the industry classifies those funds and today I wanted to explain the key differences between Mutual Funds, Index Funds and Exchange Traded Funds (ETFs). 

An investment fund is an investment product created with the purpose of gathering investor’s capital and investing that capital collectively through a portfolio of financial instruments such as stocks, bonds, and other securities.  For today’s discussion, we will focus on funds that invest in stocks.

A stock fund is an investment product that includes a portfolio of individual stocks.  Most stock funds contain at least 20 individual stocks and often own as many as 100 individual stocks in the fund.

There are two aspects of funds to help us understand some of the differences.  The first aspect is how often the price of a fund is calculated and that influences how it can be traded.  The second important aspect is how the stock selections are made in the fund. 

Mutual funds have been around the longest and, therefore, that term is more well known to people.  The key difference for mutual funds is when the fund can trade and when it’s Net Asset Value is calculated.  Mutual funds can only be bought and sold at the end of the trading day which is when the fund’s Net Asset Value is calculated.

The closing price of each stock in the mutual fund is used at the end of the trading day to calculate the weighted average price of the mutual fund – the Net Asset Value.  Since an accurate price is only known at the end of each trading day, it is not possible to establish a fair price for trading during the day. 

An Exchange Traded Fund (ETF) can be traded during the day because its price is calculated in real-time throughout the trading day.  High speed computers are needed to make these ongoing calculations throughout the day.  Because a current market price is calculated throughout the day, buying and selling shares in an ETF is much more efficient and flexible than mutual funds.

An index fund can be a mutual fund, or it can be an ETF.  Most index funds that we recommend are of the ETF variety.  So, an index fund is not different because of the way it trades or how its price is calculated.  An index fund is different than other funds because of the way that the stock selections are made inside the fund.

An index fund’s investments are driven by the index that the fund is designed to track.  For example, I talk a lot about S&P 500 index funds.  The S&P 500 index is a list of the biggest 500 companies that trade on the US stock exchanges.  An S&P 500 index fund owns all of the stocks in the S&P 500.  S&P index funds are managed by a computer and not a fund manager.  There are no investment decisions for index funds.  They simply use computers to keep track of the changes of all of the stocks in the index to arrive at a price for the fund – its Net Asset Value. 

Let me provide an example of how these definitions impact your trading.  Let’s say you want to sell $20,000 worth of a money market fund that you own and you want to use that $20,000 to buy shares of an S&P 500 index fund which is an ETF.  Money market funds are mutual funds, so they can only be traded at the end of the day.  During the first trading day, you would need to sell the $20,000 in the money market fund.  You would have to wait until the second trading day to buy the S&P 500 fund because the cash would not be available from the sale of the money market fund until the next trading day. 

If you have a 401K account, all trades are handled by the account administrator and are most often executed on the second trading day after you submit your changes to your investment allocations.  So, for 401K accounts, you don’t have to worry about any of the timing of the trades or the Net Asset Value calculations. 

Stay Disciplined My Friends,

Phil

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Investing in the financial products discussed in the Newsletter involves risk. Trading in such securities can result in immediate and substantial losses of the capital invested. Past performance is not necessarily indicative of future results. Actual results will vary widely given a variety of factors such as experience, skill, risk mitigation practices, and market dynamics.