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Picking stocks is extremely difficult. Study after study has taught us that, in the long run, the market outperforms the majority of investors picking individual company stocks. Nobel Prize-winning economist Paul Samuelson made the point forcefully all the way back in 1974: “Perhaps there really are managers who can outperform the market consistently – logic would suggest they exist. But they are remarkably
well-hidden.”
Samuelson’s point is still good wisdom today. Individual companies rise and fall – often unpredictably – but markets steadily rise, at least over long time horizons. That’s why it’s often best to buy an index fund, an ETF, or a mutual fund that invests in a large pool of diverse assets.
But how do you decide? Below we’ve unpacked the key characteristics of index funds, mutual funds, and ETFs, to help you navigate the crowded field of investment choices.
What are index funds?
If smart money is on the overall market, how do you buy in? The easiest way is with an index fund. That’s because they replicate the performance of a market index. The most common examples are funds that mirror the Standard and Poor’s 500 index (S&P 500), which tracks the top 500 listed US companies. The average yearly return of the S&P 500 was about 12 percent over the ten year period ending in December 2023. Not bad.
There are loads of other index funds. You can follow US tech companies with the Nasdaq Composite, or blue-chip stocks in London with the FTSE 100. Do you think Tokyo is the future? You can follow Japan’s market with the Nikkei 225. Other indexes track sectors. In all cases, you’re putting your money into a large, broad basket of stocks (The Nasdaq Composite tracks over 2,500 companies).
If you’re looking into multiple funds that track the same index, you may want to see which fund most closely tracks the index’s performance.
Pros and cons of index funds
The benefits of index funds are many: the large number of stocks offers instant diversification and less volatility. Their performance is usually more predictable, especially when invested in classic big indexes like the ones listed above.
And because they aren’t actively managed, they typically have low management fees. The lower expense ratio – meaning how much you pay to own the fund – means they can outperform funds that carry higher fees for active management, even if the underlying stocks do a bit worse.
That said, with an index fund you can only match the market. You will never beat it. That also means in a bear market you’re likely to do poorly. If your time horizon is shorter, you may want to explore other options.
What are mutual funds?
A mutual fund is simply a pool of investor money, usually managed by an investment professional. In some cases, mutual funds can also be passively managed – some are simply index funds as well.
More common however is the actively managed mutual fund. Here a portfolio manager will select some combination of stocks, bonds and other securities while monitoring performance and making adjustments.
Pros and cons of mutual funds
Mutual funds can offer more tailored investment strategies. Perhaps you want long-term growth, but you also have some tolerance for risk. Your portfolio manager can invest in a mix of tried and true companies while also selecting a handful of lesser known, earlier stage companies that have potential to take off. Or you can focus your investments around specific goals, like dividend income.
Mutual funds can beat passive funds in a down market. That was the case in 2022. That’s because they’re actively trying to outperform the market. They have the flexibility to adjust to what’s happening, unlike passive index funds.
That comes with a catch. Because they’re actively managed, mutual funds tend to have higher fees. That is changing however. From 2002 to 2022, mutual fund fees were cut by more than half. This is largely a response to the rise of lower cost funds like ETFs (more below). Mutual funds saw outflows of $512 billion in 2023 versus $592 billion of inflows to ETFs.
How are ETFs different from mutual funds?
Like mutual funds, exchange traded funds (ETFs) are pools of money invested in a broad basket of securities. Most ETFs are also a type of index fund. You can buy an ETF that tracks the S&P 500 or the Nasdaq. You can also buy niche ones, like ETFs that track coffee or video game companies.
Read more about: Halal ETFs Investment
There’s a few key differences between ETFs and mutual funds.
The first is how they trade. Mutual fund investors can only buy and sell once per day, after the market closes and at what is called the net asset value. ETFs can be bought and sold during intraday trading, as if they were stocks. That makes them great if you’re looking to react to the market quickly. They’re highly liquid.
Unlike mutual funds, most ETFs are passively managed. That typically makes their management fees lower than mutual funds, something which has helped them grow in popularity. The number of ETFs have been on the rise for years, growing much faster than mutual funds. While 530 new ETFs launched in 2023, just 169 new mutual funds were rolled out.
For small investors, ETFs are often a better choice. That’s because small investors can buy in for the cost of a single share. Mutual funds tend to have minimum initial investments that can range from a few hundred dollars to a few thousand dollars.
References
Indexing Versus Active Mutual Funds Management
Actively Managed Funds Did Better Than Usual in 2022
Mutual Fund Fees Declined by Near Record Amount Last Year
Mutual Funds Net Asset Value
