Mutual Funds vs. Index Funds vs. ETFs

We're going to talk a little bit about mutual funds and ETFs.

And I got a question in the.

Resident webinar recently that was basically, what.

Is the difference between mutual funds, index funds and ETFs?

And I forget sometimes, and please forgive me for this, but I forget sometimes.

That the stuff that I live and.

Breathe every day that I've known for.

Decades and is just part of my.

Vocabulary is not necessarily part of yours.

And so let's just go into this and explain all things here so that we're all on the same page and.

You know what we're talking about right now. Mutual funds are super important when it.

Comes to appropriate investing plans. Every one of you needs to understand.

The basics of mutual funds.

They are and should be, frankly, the mainstay of investing. What is a mutual fund? A mutual fund is simply a group of people banding together to invest their money together. By doing so, they enjoy a number of benefits, right? They get professional management. You hire a professional management team to buy, sell and trade securities like stocks and bonds.

And to manage the fund.

You get economies of scale, right?

The costs of hiring all these professionals and running a fund are, are dramatically.

Lower as a percentage of your investment. When you band together with tens of thousands of other investors, instead of just.

Being your own one investor, you get.

The benefits of government regulation. Mutual funds are pretty highly regulated industry. And while the first one was founded in 1924, the Investment Company act of 1940 is actually the one that set.

Out most of the rules by which mutual funds are governed today.

You get broad diversification, right? You don't get that with hedge funds. You don't get that with private investing funds. But a mutual fund has to be diversified. It was interesting. I looked up the minimum amount of diversification the mutual fund can have. Here's what it can do and still pass regulation. You can have 25% of the fund in one stock, 25% in another stock, and 5% of the fund in each.

Of 10 more stocks or other securities.

So the minimum is 12 in a mutual fund.

And nothing can be more than 25% of the fund.

But in practice, nearly all mutual funds own at least 50 securities. Most own more than 100.

And lots of them own thousands of different securities, sometimes, particularly with bond funds, tens of thousands of securities.

So you get this massive diversification. You also get daily liquidity. The funds are required to invest at least 85% of their portfolio into liquid securities, those that can be traded any day the market is open. But in practice, Most funds invest nearly.

All of their money in liquid securities of some type.

Plus you have liquidity. You can take all of your money out of your mutual funds pretty much any day the market is open, right? It's a matter of hours until the.

Money is in cash for the most part.

And so super, super liquid is basically.

A level of liquidity similar to your bank account. You don't get that if you're investing in the rental property down the street or a syndication that might tie your money up for three years or even 10 years. You don't get that sort of liquidity.

And they're readily available. Mutual funds are available everywhere.

You can get them in brokerage accounts at every brokerage. They're available in your 401k, your 403b, your 457b, your 401a, other employer provided retirement accounts.

They're in your self employed retirement accounts, simple IRAs, SEP IRAs, solo 401ks, they're in IRAs, right? They're in HSAs, they're in education savings accounts, they're in able accounts for your disabled kid. All right? Basically everybody agrees that this is a.

Great investment that's ideal for both rookie and advanced investors. So they're available all over the place.

All right? Now you know what a mutual fund is. There are a couple of different ways to manage a mutual fund. And there's some overlap, right, between these two ways. But in general, there are actively managed funds and there are passively managed funds. In an actively managed fund, the management team is buying securities they think are.

Going to do well, right?

They're buying the stocks that want to go up, they're selling the securities that.

They think are going to go down.

And they use all kinds of different.

Methods to try to figure out in advance which ones are going to do best.

The second method, passive management, is where you just buy all the securities of.

A certain type, right?

This is usually in proportion to some type of index or a list of all the securities.

For example, you've heard of the s and P500.

It's a list of 500 representative large US companies. So an index fund that's designed to follow the s and P500 index just buys all of those 500 stocks and in the proportion that they exist in the market, and the investors get whatever those stocks return, minus a piddly little tiny management fee. And there was debate for many years, for decades about the merits of index fund investing, but it's kind of settled now. If you look at the data, you're going to conclude that oh, I should be investing all my money in index funds instead of actively managed funds. It turns out it's pretty difficult, especially after the costs of all that analysis.

And implementation and particularly if you're in a taxable account. Tax costs of active management so all the long term studies are very clear that the vast majority of actively managed funds will underperform a well run index fund investing in the same securities.

So index funds are just these passively managed mutual funds.

That's all they are.

So all index funds are mutual funds.

But not all mutual funds are index funds.

Okay, mutual funds versus exchange traded funds.

Right.

There's two main types of mutual funds in use today. Before 1990, actually 93 in the U.S. all mutual funds were what we refer to now as traditional mutual funds that might be abbreviated TF or mf. Investors could buy new shares or they could sell their old shares at 4pm Eastern any day the market was open. Well in the early 90s, someone got the bright idea to allow investors to just trade their funds all day long.

While the markets are open.

So those funds are called exchange traded funds or ETFs. And obviously most of you have no need whatsoever to buy and sell your funds at 11:37am and 2:21pm it turns out there are some other significant benefits to ETFs that have made them ever.

More popular for investors.

The most significant of these is increase in tax efficiency of most ETFs when compared to most traditional mutual funds. When a traditional fund has to sell.

A bunch of securities in order to.

Give the investors their money back, it incurs capital gains and it has to by law pass these on to the investors. However, the way the ETFs are bought.

And sold allows for the fund to.

Give a basket of highly appreciated shares of securities to what's called an authorized participant or an AP in exchange for cash. So this authorized participant, which is, you know, this is a big bank is.

What they are usually this is Morgan Stanley, this is bank of America, etc.

They're authorized to create and redeem these shares of an ETF by putting together the securities that are in the etf. So this creation redemption process ensures that the net asset value, that's the price of the etf, is always equal to the value of the underlying securities. Now mutual funds, these traditional funds are generally open funds. And so the value of that fund is set equal to the value of the underlying securities at 4pm Eastern every day. But even before ETFs there were some closed Traditional funds were. That isn't actually the case. And the fund sometimes trades at a premium, right, or a discount to the value of the underlying securities. People would actually pay more for the fund than if you just made the fund yourself by buying all the underlying stocks, or they'd get it at a discount. And that disconnect in price was generally a bad thing.

So people kind of avoided these closed.

Funds, even though they could be traded on an exchange. But that ETF structure they came up with totally eliminated that.

And so, you know, basically nobody invests in closed funds anymore. And fewer and fewer people are investing in open funds because ETFs are just so darn convenient for most of us.

But the main way this ETF becomes.

More tax efficient is that it has this method now to flush these appreciated.

Securities out of the fund without giving the investors capital gains.

So when it's time to redeem a.

Share, the fund simply gives the most highly appreciated shares to the authorized participant, which can then do what they want with them. But whatever they do with them, it.

Doesn'T pass the capital gains onto the fund investors.

Why does the authorized participant do this? Well, they're making a little bit of.

Money through each trade, through arbitrage, right, Through a little premium they get where they get a little bit more from the stocks than they had to pay for the share of the etf. And so it works out for them. All they have to pay taxes on is the arbitrage. So it's a relatively small amount of tax they have to pay.

And what happens to all those capital gains?

Poof. They just go away.

Nobody pays the taxes on them. So for that reason, ETFs in general.

Are much more tax efficient than a.

Traditional mutual fund, unless you're a Vanguard or now dfa. Vanguard decades ago patented a structure where their largest index funds had a traditional fund share class and an ETF share class. And the cool thing about that structure is that it allowed investors to just use traditional funds and have the same tax efficiency as ETF investors. So it was really cool thing Vanguard did. The patents run out, and so other companies are starting to do it.

The only other one I can think.

Of right now that does it is dfa.

But I'm sure it'll become more and more popular over time.

So most ETFs happen to be index funds, and certainly most money that's invested in ETFs is invested in ETFs that are index funds. However, not all ETFs are index funds. All ETFs are a type of mutual fund though. So sometimes people use the term mutual fund when they're referring only to traditional funds, including both open and closed. And that's kind of a non precise.

Use of terminology that can confuses lots of beginning investors. But that's the difference between traditional funds and ETFs. Mutual funds, index funds Hope that terminology is more clear. Now the question lots of people are.

Left with is oh, should I use traditional mutual funds or ETFs?

For the most part, it doesn't matter. It particularly doesn't matter if you're investing in any sort of a tax protected account like a 401K or 529. If you're in a taxable account and.

You'Re not using Vanguard or DFA funds.

There'S a good chance you're better off using an ETF.

But the reason lots of people use.

ETFs even in 401ks is sometimes you can just get lower costs. Like I have accounts at Fidelity and schwab, I have 401s there and I still prefer Vanguard funds, but I buy the ETF version of those funds at Fidelity and Schwab because the commissions are lower. And so you got to look at the flexibility you want versus the hassle of having to put in buy and.

Sell orders during the day. And you got to consider the costs.

And then of course there's a tax efficiency angle if you're in a taxable account.

But honestly, a passive versus active fund.

Issue matters a whole lot more than the ETF versus traditional mutual fund issue. So don't beat yourself up. You're investing in mutual funds, it's fine. If you're just all in traditional funds, that's not a problem. I still invest in both types of funds, so hope that's helpful to you.

The hosts of the White Coat Investor are not licensed accountants, attorneys, or financial advisors. This podcast is for your entertainment and information only. It should not be considered professional or personalized financial advice. You should consult the appropriate professional for specific advice relating to your situation.