A Quick Look: Mutual Funds, ETFs, Index Funds. Diversifying Your Portfolio

Funds are a great tool for investors to diversify their portfolio. Mutual funds, Index funds and Exchange Traded Funds (ETFs) all allow you to invest in a basket of securities as opposed to picking out individual stocks, bonds etc. A lot of investors, especially passive investors, do not want to invest the time, and don’t believe in the long term success of picking individual stocks. Instead they would much rather benefit from the overall movement of the market or a specific sector. In many ways this makes sense because it is very difficult to consistently pick winning stocks (or other instruments) over a long period of time, and it’s much easier to predict the success of a sector or the market as a whole in the long term.

All three of these instruments allow you to invest in a basket of securities. The difference is in terms of factors such as method of picking securities, fees, tax benefits, dividend reinvestment and frequency of trading.

Mutual Funds

Mutual funds have a fund manager who picks the securities that go into the basket of securities that the fund represents. This is called an “Actively Managed Fund”. The pitch is that the fund managers have several years of expertise and access to resources that will allow them to “beat the market” with their returns and you are better off if you let them manage your money as opposed to you picking investments on your own. This comes with a management fees of usually around 1-3% of your assets annually. Although this does not sound like a lot, in the long term this could prove to be expensive when you are dealing with larger sums of money and account for the compounding effect. It is important to note that most mutual funds fail to beat the market consistently over a period of time and the returns are lower than advertised when you account for hidden fees and taxes.

(Note: The fees for fund instruments, especially mutual funds can vary widely depending on the company you are buying from and the type of fund you are buying. Often there are additional hidden fees that are not initially mentioned during marketing. Be sure to do your due diligence.)

Index Funds

Index funds, unlike mutual funds, are not actively managed by a fund manager. As a result, they have much lower fees. An index fund mimics the movement of major indices such as S&P500, Dow 30, Russell 2000. Indices are tools used to measure the overall performance of the market, or a certain sector of the market. They represent the overall movement of a chosen list of securities. For example, the S&P 500 represents 500 of the biggest companies and the share prices of these selected 500 companies are all factored into calculating the price of the S&P 500. Usually when people say “the market is down/up today” they are talking about the S&P 500.

Index funds can be bought and sold once a day through fund companies like Vangaurd , and their fees are usually low (around 0.1% of assets annually) since they are not actively managed. Index funds are a great tool for passive investors who do not plan on getting in and out of the market multiple times a year, and just want to benefit from the overall movement of the market.

ETF

ETFs are very similar to index funds in that they mimic indices or a predetermined list of securities, and have very low fees since they are typically not actively managed. However the biggest difference is that ETFs trade on an exchange, unlike Index funds. So you would be buying them through a broker that provides you a platform, and hence pay transaction fees. ETFs are more suitable to investors who are more active and want more liquidity making it easier to get in and out of their positions when they want.

Depending on your preference and style of investing, you could choose any of the above three types of instruments to diversify your portfolio. Please note that the fund market is massive and very broad, so the fees you pay and the minimum deposits required could vary a lot.

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