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 .
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.