Mutual Funds and ETFs

The text below is provided for informational purposes only. It is not investment advice; you must do your own due diligence before making any investments. By reading beyond this point, you agree to hold the owner of this website harmless for your investment decisions.

Mutual Funds
A mutual fund consists of a set of stocks or bonds that are selected by the fund manager.  The fund can be broad based or can be focused on a specific theme (e.g. technology, health care).  They provide diversity because the manager will invest in many individual stocks or bonds.  Fees for mutual funds depend on whether they are actively or passively managed (more on this point later).  Some mutual funds have “loading fees” that are assessed when you buy.  Others may charge fees when you sell.  You need to read the fund’s prospectus to understand the fees you may incur, as well as the goals and risks of the fund.

Index Funds
An index fund is a type of mutual fund that consists of a set of stocks or bonds that are selected in a way to mirror or track the performance of a financial market index, such as the S&P 500. They are a form of passive investing because there is no need for the fund manager to select or research stocks or bonds. They simply invest algorithmically according to the chosen index. Because there is no need to do research, these funds are low cost (usually 0.1% or less of assets invested) compared with actively managed funds, which typically charge 0.5% to 1%, but may charge as much as 2.5%. Index funds do not seek to beat the market; they just follow it, on the theory that, in the long run, the market will produce good returns. Actively managed funds do attempt to beat the market, but have to do so by a sufficient margin to justify the higher fees involved.

Orders to buy or sell an index fund are processed at the end of the trading day.

Exchange-traded Funds (ETFs)
ETFs are similar to index funds, in that they consist of a set of stocks or bonds that can be chosen to track an index.  ETFs, however, have their net asset value (NAV) recalculated continuously as the values of the stocks or bonds involved change throughout the day.  Thus, they can be bought and sold much like a stock while the market is open.  ETFs may require less of an initial investment than a mutual fund, which often has a minimum initial investment (e.g., $1000 or higher) and a minimum for additional investments (e.g., $250), whereas you can buy just one share of an ETF at a time.

Because ETFs trade like stocks, there may be transaction costs to consider, whereas mutual funds typically do not charge transaction fees (unless they have loading charges).  As noted earlier, however, mutual funds do have management fees.  Another important difference between mutual funds and ETFs is that ETFs are generally more tax efficient.  You incur capital gains (or losses) only when you sell your ETF shares.  With a mutual fund, however, the manager may need to sell shares to pay investors who are selling, thereby generating capital gains or losses.  Mutual funds are required to pay the capital gains to their shareholders.  Thus, you may need to pay taxes on capital gains even if you did not sell any of your shares and even if the fund has lost value.

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