What's the Difference Between Mutual Funds, ETFs, and Index Funds?

Investing in the stocks is a great way to build wealth in the long run. Even when the market is down — like it is right now, about 21% from recent highs — stocks can be a great long-term investments, since history shows prices will eventually rebound.

But getting started can be confusing. Long gone are the days when you called a broker with a shingle down on Main Street and asked for 100 shares of General Electric. Today, there are all manner of investment vehicles — known as funds — that help you buy baskets of stocks, or bonds all at ounce. That's great news, since your aim should be to build a diversified portfolio, at a low overall cost. Diversifying your investments will help you avoid betting too much money on any particular company or type of investment.

The problem is, with so many different kinds of funds, it's easy for a beginner to get confused. If you're ready to get started buying stocks (or just curious) here are the similarities and differences of the three most basic options: a mutual fund, index fund and ETF.

What is an active mutual fund?

A mutual fund is a basket of stocks, bonds, or other types of assets. This basket is professionally managed by an investment company on behalf of investors who don’t have the time, know-how, or resources to buy a diversified collection of individual securities on their own.

In exchange, the fund charges investors a fee, which may run around 1% of the amount of money you have invested annually or more. That means $100 for every $10,000 you invest.

In the case of most stock funds, holdings are selected by a portfolio manager, whose job it is to pick the stocks that he or she thinks are poised to perform the best while avoiding the clunkers. This process is referred to as “active management.”

But “active management” isn’t the only way to run a mutual fund.

What is a passive index fund?

An index fund adheres to an entirely different strategy.

Instead of picking and choosing just those stocks that the portfolio manager thinks will outperform, an index fund buys all the shares that make up a particular index, like the Standard & Poor’s 500 index of large-company stocks or the Russell 2000 index of smaller ones. The aim is to replicate the performance of that entire market.

But because index funds buy and hold rather than trade frequently — and require no analysts to research companies — they are much cheaper to operate. The Schwab S&P 500 Index fund, for example, charges just 0.02% annually, or $2 for every $10,000 you invest.

By definition, when you own all the stocks that make up a market, you’ll earn just the “average” return of all the stocks in that market. This raises the question: Who would want to settle for just “average” performance?

As it turns out, plenty of investors around the world. While it’s counter-intuitive, academic research has shown that the higher expenses associated with active management and the inherent difficulty of picking winning stocks consistently over long periods of time means that most funds that aim to beat the market actually end up behind in the long run.

Indeed, mutual fund researcher Morningstar regularly studies the performance of actively managed funds. Over the past 10 years, fewer than one in 10 actively managed blue-chip stock funds have outperformed comparable index funds and only about 20% small-company stock funds have done so.

What are ETFs?

Okay, index funds sound like a good bet. But what type of index fund should you go with?

Broadly speaking, there are two types. On the one hand, there are traditional index mutual funds like the Vanguard 500 Index Fund. Then there are so-called exchange-traded funds, such as the SPDR S&P 500 ETF. Both will give you similar results, but they are structured somewhat differently.

For starters, with a mutual fund, you often buy and sell shares directly with the fund company. The fund company will let you trade those shares once a day, based on that day’s 4 p.m. closing price.

ETFs, on the other hand, aren’t sold directly by fund companies. Instead, they are listed on an exchange, and you must have a brokerage account to buy and sell those shares. Historically, that has made ETFs more expensive for long-term investors, since you needed to pay a commission each time you want to buy or sell. In the past few years, however, a price war among online brokers has changed all that with most now offering free trades for stocks and ETFs.

That means ETF investors can now get the convenience of buying and selling in the middle of the day at no extra cost. So does that mean you should go with an ETF over a mutual fund? It still isn't a no-brainer. For one thing, with sometimes fast-moving prices, trading on the open market requires more skill than simply logging on to a fund company website and ordering mutual fund shares at the end-of-day price.

There's also the matter of psychology. The trick to profiting in the stock market is to stay invested for the long term. However, studies show individual (and oftentimes) professional investors have a tendency to trade too much in response to dramatic market moves, like the ones we've experienced over the past few weeks. As a result, they end up making rash calls that ultimately hurt their returns. For many average investors there is no big down side, and perhaps a benefit, to being a step removed from the action.

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