MONEY Ask the Expert

What’s the Difference Between an Index Fund, an ETF, and a Mutual Fund?

Investing illustration
Robert A. Di Ieso, Jr.

Q: What is the difference between index funds, ETFs, and mutual funds? — Gary

A: An easy way to think about it is this: Exchange-traded funds, or ETFs, are a subset of index funds; and index funds are a subset of mutual funds.

“It’s like a funnel,” says Christine Benz, director of personal finance at fund tracker Morningstar.

Let’s start with the broadest of the three categories: mutual funds.

What is a mutual fund

A mutual fund is a basket of stocks, bonds, or other types of assets. This basket is professionally managed by an investment company on behalf of investors who don’t have the time, know-how, or resources to buy a diversified collection of individual securities on their own.

In exchange, the fund charges investors a fee, which may run around 1% of assets annually or more. That means $100 for every $10,000 you invest.

In the case of most stock funds, holdings are selected by a portfolio manager, whose job it is to pick the stocks that he or she thinks are poised to perform the best while avoiding the clunkers. This process is referred to as “active management.”

But “active management” isn’t the only way to run a mutual fund.

What is an index fund

An index fund adheres to an entirely different strategy.

Instead of picking and choosing just those stocks that the portfolio manager thinks will outperform, an index fund buys all the shares that make up a particular index, like the Standard & Poor’s 500 index of blue chip stocks or the Russell 2000 index of small-company shares. The aim is to replicate the performance of that entire market.

But because index funds buy and hold rather than trade frequently — and require no analysts to research companies — they are much cheaper to operate. The Schwab S&P 500 Index fund, for example, charges just 0.09%, or $9 for every $10,000 you invest.

By definition, when you own all the stocks that make up a market, you’ll earn just “average” returns of all the stocks in that market. This raises the question: Who would want to settle for just “average” performance?

As it turns out, plenty of investors around the world. While it’s counter-intuitive, academic research has shown that the higher expenses associated with active management and the inherent difficulty of picking winning stocks consistently over long periods of time means that most funds that aim to beat the market actually end up behind in the long run.

“In general, active funds have not delivered impressive performance,” Benz says. Indeed, S&P Dow Jones Indices has studied the performance of actively managed funds. Over the past 10 years, less than 20% of actively managed blue chip stock funds have outperformed the S&P 500 index of blue chip stocks while fewer than 15% of small-company stock funds have beaten the Russell 2000 index of small-cap shares.

What are ETFs

Okay, index funds sound like a good bet. But what type of index fund should you go with?

Broadly speaking, there are two types. On the one hand, there are traditional index mutual funds like the Vanguard 500 Index. Then there are so-called exchange-traded funds, such as the SPDR S&P 500 ETF SPDR S&P 500 ETF SPY -0.31% .

Both will give you similar results, but they are structured somewhat differently.

For starters, with a mutual fund, you often buy and sell shares directly with the fund company. The fund company will let you trade those shares once a day, based on that day’s closing price.

ETFs, on the other hand, aren’t sold directly by fund companies. Instead, they are listed on an exchange, and you must have a brokerage account to buy and sell those shares. That convenience typically comes at a price: Just like with stocks, investors pay a brokerage commission whenever they buy and sell.

That means for small investors, traditional index mutual funds are often more cost effective. “If you are on the hook for trading costs, that can really eat into your returns,” says Benz.

On the other hand, because they are exchange traded, ETF shares can be traded throughout the day. Being able to trade in and out of funds during the day is a convenience that has proved popular for many investors. For the past decade exchange-traded funds have been one of the fastest growing corners of the fund business.

Read next: 5 Things You Didn’t Know About the World’s Biggest Bond Fund

MONEY mutual funds

A New Take on the Indexing Versus Actively Managed Funds Debate

And the winner is...

It’s another win for index funds.

If you’re a regular MONEY reader you’ll know the mutual fund world has been split by a long-running debate between two fundamentally different investment strategies: Active investing, where funds employ portfolio managers to attempt to select stocks that beat the market benchmarks like the Standard & Poor’s 500, and indexing, where funds aim merely to match the performance of the benchmarks.

While it may be counter-intuitive, academic research has shown that because of a) the inherent difficulty of consistently picking stocks that outperform the market averages and b) the extra costs incurred by these funds for things like research, brokerage fees, and manager salaries, only the most skillful stock pickers actually end up beating the benchmarks over long periods of time. Plus, determining who those managers are in advance is a fool’s game.

Not surprisingly, given the livelihoods at stake, this is a controversial conclusion. Now fund researcher Morningstar has offered up a new approach to the debate. While index funds are known for keeping investment fees as low as possible, costs can put a drag on their returns, too. So Morningstar set out to compare active funds not just to the returns of market indexes, but to the actual index funds that attempt to track them. The method could arguably yield a fairer comparison, more in line with what investors actually experience.

Unfortunately for the partisans of active management, the results were as clear-cut as those of any previous study, if not more so. Among the twelve types of funds Morningstar examined—from large blend stock funds to intermediate bond funds—the majority of active funds beat their passive counterparts in just one category over the past decade: U.S. mid-cap value.

Morningstar did find that investors could improve their odds by focusing on active funds that had lower costs. The majority of low-cost active funds, those in the least expensive quartile of their peers, beat low cost index funds in five of twelve categories, including U.S. large and mid-cap value funds.

Of course, since cost is still the key factor, that’s likely to be cold comfort to many active investors.

 

MONEY home ownership

Homeownership Hits Another Record Low

150624_REA_CantAffordHome
Alamy

Still can't afford a home? You've got company

For millions of young Americans the dream of ownership may be farther away than ever.

A decade after the housing bubble collapsed, America’s home ownership rate is still dropping, according to a new survey by Harvard University’s Joint Center for Housing Studies. Just 63.7% of American households owned their own homes in the first quarter, researchers found. That ratio is the result of 10 consecutive years of declines since nearly 70% of Americans called themselves homeowners in 2004.

What gives? Despite a bull market and improving jobs picture, many of America’s would-be home buyers—Gen Xers in their 30s and 40s and twenty-something millennials—are still trying to get out from under the financial burdens imposed by the recession.

Most Gen Xers were just buying their first homes or getting ready to trade up when housing prices peaked in 2006. As a result, they had the smallest financial cushion when the recession hit. Unable to make mortgage payments, many were forced to rent again. Today homeownership rates for this age group has fallen to a level “not seen since the 1960s,” the study found.

While Millennials didn’t fall into that trap, they’ve faced their own hurdles. The influx of older renters has pushed up what landlords can charge, making it harder for would-be first time home buyers to scrape together money for a down payment. Over the past decade, the percentage of young renters age 25 to 34 facing a “cost burden”—meaning they spend more than 30% of their income on housing—has jumped to 46% from 40%.

What can improve the situation? On a policy level the researchers call for loosening lending standards, such as offering loans to borrowers with smaller down payments or lower credit scores. Of course, given that was a big part of what got us into the housing mess in the first place, that seems like a ticklish proposition.

A better bet may be that the economy will bail us out, with a slowly improving employment situation boosting incomes. One thing that hasn’t changed: Young Americans still want to own homes. Among renters in their 20s and 30s, more than 90% hope to buy a home eventually, according to a Fannie Mae survey cited by the authors.

 

 

 

 

 

MONEY Savings

3 Strategies for Rebuilding Your Emergency Fund

first aid kit with money in it
Steven Puetzer—Getty Images

Car expenses top the list of unexpected bills that can derail your savings plan.

This is the final installment in Money’s Midyear Financial Checkup. Read our last installment on how to save on health care costs here.

Last year 47% of households surveyed by American Express reported getting hit with some unexpected expenses.

That’s what an emergency fund is for. But once you’ve tapped the account, what if it takes more than a year to rebuild it?

Lean on a Roth. Say you’re contributing $200 a month to a Roth IRA. You don’t have to stop to rebuild emergency savings, says Austin financial planner Garrett Prom. Just “keep those new contributions in a money-market fund.” This way your Roth acts as a backup safety net until you replenish your real one. Contributions to a Roth (which you’ve paid taxes on) can be tapped penalty-free, though investment gains cannot.

Sell bonds. If you aren’t funding a Roth and are looking to rebuild emergency savings all at once, do it in the most tax-efficient way. Instead of tapping a 401(k) or selling stocks, San Francisco adviser Milo Benningfield recommends selling short-term bonds in taxable accounts, since they are less likely than equities to generate big capital gains bills. Doing so could lead to a stock-heavy portfolio. So Benningfield suggests shifting some stock holdings in your 401(k) to fixed income.

Get a HELOC. Home-equity lines of credit charge 4.7%, but in some places you can get one for 3.25% with a credit score of 700 or higher. HELOC interest payments are typically deductible. But since one possible emergency is a job loss, it’s best to open the line of credit now, while you can still get the best terms, says Manhattan Beach, Calif., planner Phil Cook. “The only time bankers want to lend you money is when you don’t need it.”

Money
MONEY health insurance

3 Ways to Save on Health Care This Year

pill with $ on it
Shutterstock

With out-of-pocket costs rising, it's time to reassess your health care budget.

This is the fourth installment in Money’s Midyear Financial Checkup. You can read our first installment on how to recalibrate your investments, our second installment how to to negotiate a raise, and our third installment on how to lower your tax bill.

Last year out-of-pocket medical expenses soared 11%, according to TransUnion. And since health care is typically one of the biggest budget busters, there’s a good chance you have to reexamine your own spending or rethink how you plan to cover costs.

Compare costs. More than three-quarters of large employers offer tools that let you compare costs for procedures of the doctors and facilities in your health plan, according to Mercer. If your plan doesn’t, visit Guroo.com, which lists costs based on national averages.

Use rising costs to your advantage. There’s a good chance you may have already met your deductible. In that case the second half of the year is a good time to schedule nonurgent procedures like knee or hip surgery or physical therapy. “It will save you from having to pay your full deductible two-years in a row,” says financial adviser and doctor Steve Podnos.

Boost your HSA dosage. A health savings account allows you to set aside up to $3,350 tax-free this year (up to $6,650 for families) to pay for medical bills. The money can be invested tax-free, so anything left over grows, as in an IRA. Yet the average contribution is just over $1,000, well below the limit, according to Aon Hewitt. If you have an HSA, you can raise contributions to meet medical needs even after an illness. “If your kid breaks his arm, you can put the money in tomorrow,” says Todd Berkley, who runs AskMrHSA.com, “and have the government pay a quarter of your bill.” The catch is the HSA must have been open at the time of the health event.

MONEY Taxes

3 Tips for Trimming Your 2015 Tax Bill Now

immunization shot with dollar sign bubble in liquid
iStock Boost your immunity to taxes.

Sell before you lose the chance.

This is the third installment in Money’s Midyear Financial Checkup. You can read our first installment, on how to recalibrate your investments, here, and our second, on how to negotiate a raise this summer, here.

Rebalancing your portfolio by selling stocks makes a lot of sense after the fourth longest bull market in history. But it’s not so simple. You know that selling long-term holdings at a profit has a bad side effect: capital gains taxes.

Use losses to offset gains. When you sell a long-term holding that’s down, Uncle Sam compensates you for part of that loss. How? By letting you use those capital losses to reduce, dollar for dollar, any capital gains you have elsewhere in your portfolio. The good news: If you wind up with more losses than gains, you can use them to lower your taxable ordinary income up to $3,000 a year. Even better, you can carry forward leftover losses indefinitely, which means you can lower your tax bill for future years when you rebalance.

Sell before you lose the chance. Even though the market is modestly up this year, losses can be found in a number of areas, including European equities, emerging-market stocks, commodities, natural resource funds, and the energy sector (see chart). Investors often wait until the end of the year to harvest losers. But “if you wait until then, you might have fewer opportunities,” says Los Angeles financial adviser Ara Oghoorian. He adds: “You don’t know where the market will be in December.”

Maintain your strategy. While rebalancing reduces risk, you don’t want to change the makeup of your portfolio. So when you sell, immediately replace your losers with the same type of—but not identical—investments. The IRS’s “wash sale” rule restricts you from buying back the same security you just sold for 30 days if you want to keep the tax break. However, this still leaves you plenty of room to maneuver, says tax expert Robert Willens.

For instance, if you sell Exxon Mobil EXXONMOBIL CORPORATION XOM -0.32% , whose shares have sunk 14% in the past year because of weak oil prices, there’s nothing stopping you from swapping it for a peer like Chevron CHEVRON CORP. CVX -0.87% , which generates a greater percentage of its energy production from oil and is therefore more likely to bounce back as crude prices recover. Or you can buy a broad-based energy fund like Vanguard Energy ETF VANGUARD WORLD FDS VANGUARD ENERGY ETF VDE -0.98% , which charges just 0.12% in annual fees.

Money
MONEY Workplace

Why Summer Is a Great Time to Ask for That Raise

150603_INV_ShapeforRaise
iStock A raise can help you get in better shape, financially.

Midyear is the best time to negotiate a salary bump.

This is the second installment in Money’s Midyear Financial Checkup. Read the first installment, on how to recalibrate your investments, here.

You’ve suffered through years of stagnant wages. But in 2015 workers stand the best chance of getting a raise since the financial crisis, according to a PNC survey of small and midsize businesses late last year. Midyear is the best time to negotiate a bump because budgets are still flexible and you’ll have time to make your case with your boss, says Lydia Frank, editorial director at PayScale.com. Wait until year-end, at your annual performance review, and you’ll run into stiff competition for raises.

Here’s how to do it.

Demonstrate your value. Not only will this increase your odds of getting a raise, it could boost the amount (see chart below). Start by requesting a midyear review. This will let you know if you’re on track to meet this year’s goals. It’s also a chance to remind the boss of your accomplishments.

Play mind games. At the meeting, provide a specific range of pay you’re seeking. This makes you look flexible, but it also anchors a figure in your boss’s head. For instance if you want $90,000, set a pay range of $90,000 to $95,000. Behavioral studies show discussing a number first and then making your case works best. Finally, offer a written summary highlighting your accomplishments. This will make your achievements concrete for your supervisor, Frank says.

Hedge your bets. “Experience is in demand,” says Steve Gross, senior partner at consulting firm Mercer. Execs willing to jump ship are likely to command a 15% bump. Even if you prefer to stay put, having an offer can help you negotiate with your current firm. Dip your toes in the hiring pool by signing up for a job site like Poachable, which is anonymous and lets employers come to you.

Money
MONEY stocks

Give Your Investments a Midyear Checkup

Kagan McLeod

How to ensure your wealth is still in good health.

Halfway into the year, and 2015 may have already thrown you and your financial plans for a loop.

Stocks, which were supposed to slow as the bull market entered its seventh year, are back to setting all-time highs—and have gotten frothy as a result. Gas prices, which were on the verge of plunging below $2 a gallon, have reversed course and are now headed toward $3. And the job market, once on a roll, looks to have hit another speed bump.

Okay, the changes aren’t of the magnitude of what you saw in the financial crisis. But they don’t have to be to throw your financial plans off-kilter. As with your annual physical exam, the midway point of the year is a smart time to take some vitals, run some tests, and reassess your own situation. Over the coming weeks, we’ll provide you with a wealth-care checklist. First up: a review of your investments.

STRESS-TEST YOUR PORTFOLIO

Ailment: Rising rates. The Federal Reserve says it could raise interest rates at any one of its upcoming meetings now—which would mark the first rate increase in nearly nine years.

Hiking rates is like stepping on the economy’s brakes. Historically, there’s an 80% chance stocks will fall by 5% or more once investors see Fed “tightening” as imminent. Moreover, bond prices move in the opposite direction of market rates, so fixed-income funds could take a hit too. When the Fed lifted rates in 1994, for instance, intermediate-term bond prices sank 11.1%.

Treatment: Don’t overreact. The natural inclination is to be überconservative. But market watchers from Warren Buffett to bond guru Bill Gross think global growth is slow enough for the Fed to be patient. And even if the central bank acts in the coming months, short-term rates are still expected to rise only about half a percentage point by year-end, according to a survey of economists by Blue Chip Economic Indicators.

Move to the middle on bonds. The traditional advice for fixed income is to “shorten up.” That is, sell funds holding long-maturity bonds and hide out in short-term debt that’s less vulnerable to price declines. But with short rates still near zero, you could be leaving a lot of money on the table, warns BlackRock portfolio manager Rick Rieder. Plus there’s no guarantee bonds will lose money. When rates rose in 2005, bond prices fell but investors earned 1% on a total return basis when factoring in yields. So instead of going all short, stick with intermediate funds like Dodge & Cox Income DODGE & COX INCOME FUND DODIX 0.15% , whose nearly 3% yield can soften the blow from price declines.

Stay (mostly) the course with stocks. Not all pullbacks turn into bear markets. In fact, history shows most sectors keep rising six months after the Fed starts raising rates, including economically sensitive ones like technology and consumer discretionary, notes S&P Capital IQ’s Sam Stovall. That’s why Stovall says you’re better off holding on and selling equities only if you need to rebalance. In which case…

REBALANCE YOUR INVESTMENT DIET

Ailment: A frothy market. Stocks are still on a roll, with blue-chip equity funds having posted 15% annual gains over the past three years, vs. 3% for intermediate bonds. What’s wrong with that? Based on 10 years of average profits, the price/earnings ratio for stocks is now above 27, where it was leading up to the Great Depression, the 2000 tech wreck, and the 2007 financial crisis. Even if there is selloff here, history says to expect meager returns over the next 10 years.

Treatment: Get back to your target weight. If you started with 60% stocks/40% bonds three years ago, you’re closer to 70% stocks now. Shift your allocation back before the market does it for you, says planner Eric Roberge.

Use the 5% rule: Don’t overmedicate, as rebalancing can trigger trading costs and taxes. So rebalance only if your mix shifted by five percentage points or more, says Francis Kinniry with Vanguard’s investment strategy group.

Think small: Since rebalancing is about selling high, unload your frothiest equities first. Over the past 15 years, small stocks have trounced the S&P 500 by four percentage points annually, and now trade above their historical 3% P/E premium to bluechip shares.

Sell American: In the past decade, U.S. stocks have outpaced foreign equities by 3.5 points a year. American shares now trade at a 15% higher P/E ratio than global stocks, even though they have historically traded at similar valuations.

MONEY 401(k)

How the Supreme Court Just Improved Your Retirement

The Supreme Court just ruled on an obscure aspect of ERISA. It could be great news for your retirement nest egg.

The Supreme Court just handed millions of retirement savers a helping hand.

You many not know much about ERISA, the body of rules that governs retirement accounts. But chances are you have a 401(k). That means Monday’s Supreme Court decision could indirectly lower investment fees you’re paying. And that’s great news.

On Monday the Supreme Court made it easier for 401(k) investors to sue employers over needlessly costly 401(k) investments. The actual point of contention in the case, known as Tibble vs. Edison, was pretty obscure. It involved how the statute of limitations should be applied to a breach of fiduciary duty.

But because ERISA law is so complicated, companies almost always choose to fight such suits on technical grounds. This time around, the typically business friendly U.S. Supreme Court decided in favor of investors, unanimously overruling the U.S. 9th Circuit Court of Appeals. As a result, employers will be forced to think a little harder about whether similar arguments are likely to prevail in the future.

But the fact is, employers have grown increasingly proactive about regulating plan fees. The reason: Tibble vs. Edison is just a high-profile example of a series of lawsuits launched in the past decade over employers’ failure to police exorbitant retirement plan fees. And many large employers have already reacted to the threat by urging investment firms to lower fees for their employees. As a result, 401(k) plan fees have come down, and investors have had greater access to low-cost options like index funds.

With the Supreme Court weighing in on investors’ side, you can expect that trend to continue.

 

MONEY fiduciary

If Humans Can’t Offer Unbiased Financial Advice to the Middle Class, These Robots Will

Wall Street says it can't be a "fiduciary" to everyone who wants financial advice. But the new breed of "robo advisers" is happy to take the job.

Fast-growing internet-based investment services known as robo-advisers have already begun to upend many aspects of the investment business. Here’s one more: Potentially reshaping the long-standing debate in Washington over whether financial advisers need to act in their clients’ best interests.

If you work with a financial adviser you may assume he or she is legally obligated to give you unbiased advice. In fact, that’s not necessarily the case. Many advisers—the ones who are technically called brokers—in fact face a much less stringent legal and ethical standard: They’re required only to offer investments that are “suitable” for you based on factors like age and risk tolerance. That leaves room for brokers to steer clients to suitable but costly products that deliver them high commissions.

The issue is especially troubling, say many investor advocates, because research shows that most consumers don’t understand they may be getting conflicted advice. And the White House recently claimed that over-priced advice was reducing investment returns by 1% annually, ultimately costing savers $17 billion a year.

Now the Labor Department has issued a proposal that, among other things, would expand the so-called fiduciary standard to advice on one of financial advisers’ biggest market segments, Individual Retirement Accounts. A 90-day comment period ends this summer.

Seems like an easy call, right? Not so fast. Wall Street lobbyists contend that forcing all advisers to put clients first would actually hurt investors. Their argument? Because advisers who currently adhere to stricter fiduciary standards tend to work with wealthier clients, forcing all advisers to adopt it would drive those who serve less wealthy savers out of the business. In other words, according to the National Association of Insurance and Financial Advisors and the U.S. Chamber of Commerce, a fiduciary standard would mean middle-class investors could end up without access to any advice at all.

(Why, you might ask, would anyone in Washington listen to business rather than consumer groups about what’s best for consumers? Well, that is another story.)

What’s interesting about robo-advisers, which rely on the Internet to deliver automated advice, is that they have potential to change the dynamic. Robo-advisers have been filling this gap, offering investors so-called fiduciary advice with little or no investment minimums at all. For instance, Wealthfront, one of the leading robo-advisers, has a minimum account size of just $5,000. It’s free for the first $10,000 invested and charges just 0.25% on amounts over that. Arch-rival Betterment has no account minimum at all and charges just 0.35% on accounts up to $10,000 when investors agree to direct deposit up to $100 a month.

Of course, these services mostly focus on investing—clients can expect little in the way of individual attention or holistic financial planning. But the truth is that flesh-and-blood advisers seldom deliver much of those things to clients without a lot of assets. What’s more, the dynamic is starting to change. Earlier this month, fund giant Vanguard launched Personal Advisor Services that will offer individual financial planning over the phone and Internet for investors with as little as $50,000. The fee is 0.3%.

The financial services industry says robo-advisers shouldn’t change the argument. Juli McNeely, president of the National Association of Insurance and Financial Advisors, argues that relying on robo-advisers to fill the advice gap would still deprive investors of the human touch. “It all boils down to the relationship,” she says. “It provides clients with a lot of comfort.”

But robo-adviser’s growth suggests a different story. Wealthfront and Betterment, with $2.3 billion and $2.1 billion under management, respectively, are still small but have seen assets more than double in the past year.

And Vanguard’s service, meanwhile, which had been in a pilot program for two years before it’s recent launch, already has $17 billion under management.

Vanguard chief executive William McNabb told me last week that, although Vanguard had reservations about the specific legal details of past proposals, his company supports a fiduciary standard in principle. Small investors, he says, are precisely the niche that robo-advisers are “looking to fill.”

 

 

 

 

 

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