Index Fund vs. Mutual Fund vs. ETF
This is Finance 103 - 1: Learn how to invest in an already diversified portfolio in form of an investment fund.
Stock vs. Investment Fund
When investing in few individual stocks there's a lack of diversification and therefore an unnecessary risk. Furthermore, we have scaling problem: Especially small retail investors should consider that they need to pay fixed transaction fees for every buy and sell order, regardless of the amount of stocks they are trading. Let’s say you buy one stock for 100 € and you pay 5 € transaction fees, then you have already generated a loss of 5 % on the first day. On the contrary, if you buy 1.000 stocks for 100.000 € you also pay 5 € which is only a deduction of 0,005%. Finally, there are certain stocks that you cannot afford for 100€ — for example an Amazon stock currently costs more than 1.500 €.
These two problems can be mitigated by investing in funds. Simply put, for an investment fund there is a financial instituion, that collects the investors’ money in a pot and buy securities on a larger scale. In that case, all investors pay the transaction fees just once and share it among each other.
There are different forms of investment funds. Mainly I will explain index funds and ETFs (Exchange Traded Funds) since they are the best practice.
Index Fund Meaning
An Index fund is a passive investment fund that replicates the index of a stock market. Example: If you only want to buy stocks from the biggest companies of the US you should go for the index fund S&P500. Adapting this to European stocks you would consider the Euro Stock 50, in Germany the DAX 30 and in Japan the Nikkei 225. A complete list of Market Indices can be found on Investing.com.
Index fund vs. ETF
There is a not huge difference between index funds and ETFs. Both are pasive investment funds that replicate a market index. ETF explained: They are funds that are traded on a public exchange. On the other hand, an index fund can be bought and sold directly from the investment company, which makes it more difficult to access the market. So it's more easy to trade ETFs.
In the following we use index funds and ETFs as synonym.
Index Fund vs. Mutual Fund
Mutual funds are also an option to invest in a diversified portfolio. However, the significant difference is that mutual funds are actively managed funds. This means the investors provide money to a fund manager who is buying and selling shares at his own discretrion to increase return and/or mitigate risks for the investors. However, mutual funds have bad reputation because the high fees you pay to the fund manager are usually not compensated by a higher return. Passively managed funds simply beat actively managed funds in most cases. This failure can be explained by the Modern Portfolio Theory which implies that you can only beat the market by taking disproporionate risk. So at the end, in average you'd gain less money compared to an index fund.
Mutual funds are still very common. But reason for this is in my experience that they offer high commissions to financial consultants and banks which sell them to their customers. who have no knowledge about investment at all.
Why Invest in Index Fund
The reason why to invest in an index fund is that it replicates a market portfolio. That makes an index fund a diversified investment. When going back to lesson 102 >>How to diversify a Portfolio<< we have learned that investors aim to build a market portfolio to find the best risk-return-balance. Besides, index funds are passive investments which have the advantages of low management effort and costs.
Are Index Funds Safe?
In general, if you buy index funds or ETFs at your broker, the bank will buy all stocks of the fund and store it as a special asset that is segregated from firm assets. This means even if your broker or bank gets bankrupt nobody has access to your assets. So in this case index funds are safe.
Concerning the economical terms, the index fund risk is on a medium level. This means the price volatility is usually higher compared to a government bond or on the money market. However, if you invest long-term this medium risk is mitigated to a low level. This can be explained by the fact that the market might have bumps in the short or mid term (financial crisis, corona crisis etc.) but it is empircally proven to grow in the long-term. Furthermore, if you compare single stocks with index funds, the latter have significantly lower risks due to diversification.
Index Fund Fees
The cheap index fund fees are one of the main advantages of this investment. In practice, the yearly ETF expense ratio is between 0 % and 1 % of your assets. The most famous index, the MSCI World, has an TER (Total Expense Ratio) of yearly 0,2 %. Let's say your assets are worth 10.000 €, this would involve costs of 20 €. Probably this the best price possible to create a sufficiently diversified portfolio. If you compare it to a mutual fund they require management fees up to 3 % per year which will significantly lower your return.
Other fees might be given by the broker you purchase your index fund from. This can include opening costs of your securities account, administration fees and order costs when you buy assets. However, I will show providers that do not charge these fees.
Index Fund Performance
In general, the index fund or ETF has nearly the same performance as the stocks within the index. Obviously, the index fund performance depends on the index you're reffering. Most common examples are the MSCI World and S&P 500 Indices with average returns of ~ 8% p.a. each. This is of course the historical performance that is assumed to be true for the future. However, it cannot be excluded that there future return will be lower or higher. What we expect (and my former Finance teacher will agree) is rather growing interest rates if we i investigate the pure facts:
As it can be seen on the diagram the MSCI World Index had its ups and downs. However, the green dotted trend line shows exponential growth over time. This represents our stock market and gives a hint that growth rates will be even higher in the future.
Index Fund: Pros and Cons
Index funds and ETFs are the perfect product for the investment beginner but also for the advanced investor who doesn't want to deal with his finance every day. They are very price effective and usually perform better than other investment products. Also index funds are already diversified investments. If you only invest into the MSCI World Index for example, you have 2300 stocks in 23 different countris in your portfolio. This gives you enough scattering and security in your stock portfolio.
Very advanced investor will probably have ETFs in their long-term portfolio, too. However, on a larger scale (we talk about investments beyond 1 Million €), buying single stocks can be cheaper. This is because you pay a small management fee for ETFs but not for single stocks. Instead you pay higher one time order costs for stocks, but this only peanuts if you investment some million Euros.
Also the advanced investors might apply certain strategies like investing more money during a recession to outperform the index fund. This is not certain but at least you have the chance to gain more return with stock picking.
Altogether with an Index Fund or ETF you will be on the safe side.
Where to buy Index Funds
For buying Index Funds in form of an ETF you need to open a trading account. In my article best trading accounts 2020 you will find the best broker for your needs.
Index Fund to invest in
In part 2 of this article you will learn in which Index Funds and ETFs you can invest in.