Mutual Funds vs Index Funds vs ETFs

Investing does not have a particular straightforward formula. It is a very relative concept. Why is it said to be a relative concept? The reason is that a particular investment's suitability varies based on background of a person, his/her financial goal, stage of life a particular person is in, amount of risk that a person can take and many more factors. Firstly, it is crucial to have knowledge about all investment options, their differences in order to take a decision.

It is very commonly seen that, there is a lack of understanding related to what are Mutual Funds, Index Funds and Exchange Traded Funds and how they are different. Many a times Index Fund and ETFs are used interchangeably because they are similar. But that's not correct as there is a difference between the two.

So let's get started!

MUTUAL FUNDS

Mutual Funds came way before Index funds and ETFs. Earliest known MF was started way back in 1800s. The first modern-day mutual fund was started in 1924 by the name of 'Massachusetts Investors Trust'. 

The aim for creating them was to pave a way for a bunch of people to pool their money and make investments together. 

What do MFs offer? 

• The first thing that Mutual Funds offer is convenience. You get to own a bunch of different stocks in one easy package. Let's imagine a world where Mutual Funds did not exist and you wanted to invest in more than one stocks. You will have to make many different purchases, which is time consuming and also more expensive as one would have to pay brokerage for each transaction. But by investing in Mutual Funds one gets to be the owner of all the stocks in which the Mutual Fund has already invested in. 
• Another benefit of Mutual Funds is that they help to diversify your investment. Diversification basically means to take the money that you were looking to probably invest in one stock and instead put it in more than one stocks (wisely) which helps to reduce your risk. So when probably the stock of one company that you invested in goes down, another maybe rising and you would lose less of your money. 
• There is a skilled professional maintaining the Mutual Fund portfolio for you and thus, you don't have to do the analysis and choosing work of which stocks to pick.

Seeing so many benefits have you already started looking for good Mutual Funds? Wait....wait continue reading ahead.

Yes! There is convenience. There is diversifiction. 

But there are also the so-called 'skilled professionals' (known as Fund Managers), who are the sailors of the ship. They actively manage the Mutual Funds, pick stocks, sell stocks and try to ensure that the returns are profitable. So, for this they charge fees which is around 1%-2% of your investment. This amount would go into fund manager's pocket even if the Mutual Fund makes losses. 

So, this means that even when investors are in loss, the fund manager would be gaining......because yeah you know he is doing his best but the market is of course not in his/her control and for this "doing his best" he/she will charge money. 

Though this 1%-2% seems small in the beginning, in the long run it really adds up and can become a huge load on your investment and the Fund Manager on the other hand, will keep on raking in million and millions and millions and.....you get it right!

INDEX FUNDS

Okay so surely someday it was to be realised that most mutual funds are not worth the hype. In the long run the returns would just not be justifiable for the huge costs. So, finally!!!!

One day, a guy named Jack Bogle decided to give the mutual funds a smack in their face (not literally :) LOL!) He decided and invented a whole new type of mutual funds, famously known as Index Funds. 

This led to a revolution in the market and unlike Mutual Funds which are actively managed, Index Funds are passively managed. So you do not have to pay as high as to the mutual fund managers to actively manage the portfolio.

Before knowing how an Index Fund works. Let's understand what is Index.

An index is a tool which summarizes the entire stock market. It represents part of the stock market and helps people to see an overview of how did the market perform in a particular time period. Instead of looking at thousands of stocks individually to find out, one just needs to look at the index such as NIFTY 50, BSE 30, S&P 500 to get an idea.

If say the index tells that the stock market rose on a particular day, it doesn't mean all stocks rose. Some may have fallen as well but based on the weight of different stocks in the market, it just provides a general picture.

Basically an index fund tracks a particular stock market index that was just explained above. The fund tries to buy and sell stocks in order to maintain their weights as per the index.

So, the first index, which is now known as the 'Vanguard 500' was created by Jack Bogle in 1975. It tracks the S&P 500, a stock market index in the US. Since, there is not much much decision making involved in an Index Funds, the fees that they charge is much less. For example, Vanguard 500 charges just 0.4% annually. "Peanuts" right?

Now here is a tongue twister. Do repeat and remember it! 

"All index funds are mutual funds, but not all mutual funds are index funds." 

An index fund would clearly state that it tracks a particular stock market index in its prospectus. But a mutual fund which is not an index fund would highlight that there is a person who makes choices and decisions in order to maintain the stock portfolio.

I hope there is clarity in the differences between Mutual Funds and Index Funds now.

Exchange Traded Funds (ETFs)

World's first ETF was introduced in 1990, exactly 15 years after the first index fund was started. This ETF came to be known as 'Toronto Index Participation Fund' which tracks 35 stock - index on the  Toronto Stock Exchange (TSE 35).

ETFs are actually very similar to index funds. There is just one major difference between the two. Index Funds can be bought or sold just once in a day. This is to reduce the too much price fluctuation that can happen when a particular asset is sold and bought just too many times in a day. 

On the other hand, ETFs can be be bought or sold any number of times in a day, just like a normal stock. Thus, experiencing more price fluctuations in other words more volatility. 

So, one should really know what their needs and requirements are. If one is aiming for the long term, like buying once and then selling only like deep down the future like 5-6 years later or even during retirement, then Index Funds would be better. 

In case one wants to trade everyday and in more than one stocks and effectively pay less then ETFs could help in that case. 

Don't take Mutual Funds as completely useless though. If one wants some advanced machanisms and invest across different segments like equity, debt, commodities then Mutual Funds can come into the picture. Plus, if you want to really reduce risk (the process is known as hedging) then the active fund managers of Mutual Funds help in that. But then you have to pay extra in the form of commissions.

That's all guys! We went step-by-step through each of the three investment options. I hope you guys understood and liked it.

In case there are any suggestions or queries, please share in the comments section.

Stay Inquisitive!

Written by: Aastik Pasricha

Disclaimer: This blog is only for informational purpose and in now way intends to propel anyone to invest in the securities mentioned above. Any investment decision should be your own based on consultation with your financial advisor and dear ones. Investing or trading involves risks thus, make decisions accordingly.