What’s The Difference Between Index Funds, Mutual Funds and Exchange Traded Funds?

jackie-main

In my last post I wrote about mutual funds and how they should not be thought of as stocks, but rather a basket of stocks. Each type of mutual fund has it’s own style and the style is determined by the manager that runs the mutual fund. As an investor, we can find out how the mutual fund is managed by reading the prospectus. That post gave us a general definition of what a mutual fund really is, but many readers who have followed my blog might have heard me mention other funds. I’m most favoured towards index funds, so I talk about them a lot. There’s also the notion of exchange traded funds that you have no doubt heard of us well. So what are all these funds? And how are they all different?

Index Funds

I’m a big proponent of index funds for the sole reason that they are cheap to own and provide the diversity necessary to reduce risk. It’s no wonder that even Warren Buffet thinks that index funds are the way to go for long term investors. Though the term index funds has been used for a long time, a lot of people don’t know what they are or what they mean.

First off, just like any other fund, an index fund is just a basket of stocks as well. In fact, they can be mutual funds too! See the word “fund” when most people talk about investing, is just referencing a basket of stocks. So whenever anyone says anything about investing in a “fund”, they are essentially buying a bunch of stocks that are packaged together. An index fund is a very specific type of fund. That means that an index fund is a basket full of stocks, but it holds very specific stocks. You may be wondering what kind of stocks an index fund holds. Good question…

TD_Index_Fund

The description above is for a TD Bank mutual fund. This fund is classified as a Canadian index fund. To be an index fund, it is following a very specific strategy and methodology when adding stocks to the basket. The objective specifically states that the capital in this fund primarily purchases equities that track the performance of the TSX Composite Index. The last sentence in the objective is what describes what this fund is trying to emulate. This index fund is comprised of Canadian companies that are traded on the Toronto Stock Exchange.

Typically index funds track the popular indices that the public are used to seeing. These are the indices that you see flashing in the news, newspapers or popular sites like Yahoo Finance or Google Finance. When someone talks about the TSX index is sitting at 16,000 it’s referring to the value of the basket of stocks that the index tracks. Just what might the index be tracking? In general, the indicies are tracking the largest companies by worth in the index. Think of the TSX as the top 250 list of the most expensive companies in Canada. That means that a good Canadian index fund should contain the top 250 companies in Canada based on net worth. It’s to no surprise that you’ll find very popular names in the basket of stocks like Rogers Communication, Royal Bank of Canada, Enbridge, etc…

A typical US Index fund will most likely track the S&P 500 index in the US. That’s the top 500 stocks in America. There are also other numerous funds in Europe and Asia that will track a combination of the top companies traded in those regions.

So an index fund can be a mutual fund because it’s just a basket of stocks. A mutual fund though is not necessarily an index fund. That’s because mutual funds can contain any combination of stocks, not just the ones that are mapped to standard indexes. If a fund manager decides to create a mutual fund that tracks companies that sell candy canes and toys that are staffed by elves, she can do so and call it a mutual fund. But an index fund it cannot be.

Exchange Traded Funds

Exchange Traded Funds or commonly called ETFs, have become a very popular type of fund because it has become synonymous with having low management fees. Again, this is a pure marketing ploy by a lot of investment companies to entice investors to use their funds. ETFs and mutual funds are no different from one another other than the way they are traded.

ETFs are traded directly on the stock market. It’s possible to find the current price of what an ETF is trading for by looking at popular finance sites like Yahoo Finance or Google Finance. Unlike mutual funds, ETFs have real-time pricing. That means when a share of the ETF is bought, the price you specify is the price you buy at. Pricing in mutual funds are totally different because they are not traded directly on a stock exchange. The price of a mutual fund is determined at the end of the day based on how the market moved. That means that an ETF has more liquidity than a mutual fund because transactions for mutual funds are completed at the end of the day after the closing price of the market.

Another difference with ETFs is that shares must be bought as a whole. That means it’s not possible to own one-fifth of a share like how a mutual fund can be owned. It’s very easy to invest $100 in mutual funds and end up with fractional shares because they can be owned that way. ETFs will require exact dollar amounts which means sometimes when there isn’t enough cash to purchase an entire share, the money just sits there in cash instead.

In general, ETFs have lower management fees, but that doesn’t mean that mutual funds don’t also have low management fees either. There are many mutual funds that can get below 1% in management fees and can be very competitive when it comes to cost of owning. One factor many people forget when trading ETFs are the high commission fees for making a transaction. Each time an order is made to trade an ETF, the brokerage will take a commission fee. Depending on the broker that you may be using, the commission fee can range anywhere from free (for purchases only) to $30. This can take a big chunk of money away that is being invested. Mutual funds on the other hand are free to trade. That’s why the cost benefit of analysis of using ETFs or mutual funds should not be solely based on the management fee, but the total cost to owning the fund.

Just like mutual funds, there can be many types of ETFs. How ETFs are managed are again determined by the fund manager. Determining how the ETF is being managed will require you to go onto the investment firm that offers the ETF and read it’s objective statement similar to the prospectus of a mutual fund. It’s common to mistake that all ETFs as index funds. This simply isn’t true. There are many ETFs that focus on specific sectors like energy, green technology, ethical companies, etc… These are not index funds, but fully managed funds that have focuses that don’t reflect the standard stock market indices. Don’t fall into the trap in believing that all ETFs are index funds.

Summary

If you didn’t have the time to digest everything in this article, these are the main facts that you need to know:

Mutual Funds – Is a basket of stocks that is managed by a fund manager based on the prospectus. Price is based on the closing price of the stock market for the day it is being traded. Can own fractional parts of a share. Free to buy and sell at any time.

ETFs – Is a basket of stocks that is managed by a fund manager based on the objective of the fund. Prices are in real-time and traded on the stock exchange. Can only own whole shares. Buying and selling generally incurs commission fees.

Index Funds – Is a basket of stocks that is managed by a fund manager but specifically tracks one of the main market indicies (S&P 500, TSX, etc..). Is a type of fund, not a product in itself. Both mutual funds and ETFs can be an index fund.

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