Understanding and Deciding Between Mutual Funds VS ETFs VS Index Funds
Updated: Sep 5
The world of investments is vast and at times confusing. One type of investment that is asked about regularly is that of index funds. We want to answer the question of how do investments in index funds work, and things to consider then thinking about investing in them.
What Are Index Funds?
“Fund” A fund is generally an investment made up of pooled resources with a common goal.
An “Index”. A way to slice up and define all possible investments by certain criteria. We put these two words together and an index fund is a pooled investment with a common goal to be tied to a certain criteria that is defined. A pooled investment is when multiple people come together and agree to pool their money together in the purchase. In doing so, you receive a portion of the investment attributed to your investment amount.
The kind of investment criteria depends on the index itself (i.e index of S&P 500, DJIA, etc.). You can be tied to an index that is all specific to a single country, a number of companies based on side, to a single commodity such as gold, or to a certain industry such as communications.
Example: The Standard & Poors 500 (S&P 500) is representative of the 500 largest companies in the US at a given period of time. So an “Index Fund” is simply a pooled investment vehicle that seeks to closely replicate the performance of an index. By holding an S&P 500 index fund, you would in theory own a piece of all 500 companies represented in that index.
3 Benefits of Investing in Index Funds
1) Greater exposure to many companies and diversification.
Purchasing into an index fund can give you exposure to hundreds if not thousands of different companies. If some of those companies do well, and others do poorly, you haven’t put all your eggs in one basket so your performance will not be tied up to one specific company.
2) Simple way to approach investing.
An index fund can offer simplicity when it comes to investing. Depending on the specific investment, you can become diversified with relatively few funds, and it doesn’t cost a lot of get started.
3) Offers transparency in what you are invested.
If you follow a specific index in your investing, you can look up and see what companies are in that index at any given time and know what you own overall. That will change as companies go in and out of an index, however, for some indexes that isn’t a frequent occurrence.
3 Drawbacks to Investing in Index Funds
1) Can’t Outperform the Index
By owning the index, you are trying to replicate the index performance and you are not trying to outperform it in that position.
2) Lack of Control of Investments Held
If you believe in owning certain types of investments or don’t like certain companies, and index fund may not be for you since you are going to own everything within that index.
3) No Options or Derivates
If you like additional strategies that allow for calls/puts/short selling and things like that, you won’t get that in an index fund.
Mutual funds vs ETFs
There are two common vehicles for saving in an index fund, a mutual fund and exchange traded fund (ETF).
In a mutual fund, there is a mutual fund manager that is purchasing every stock that is contained in that index and selling the ones that fall out of the index. Because there is buying and selling, there are taxes that can be passed on to the investors.
In the ETF, on the other hand, there is no manager, just the composite index. There is not any selling that occurs inside of it but rather an exchange, so the taxes predominately occur when you sell it.
How Are Index Funds Taxed?
If the kinds of accounts you own are retirement accounts that are Roth or pre-tax only, you can invest in mutual funds or ETFs and there will be no difference on the taxability of either one. In those accounts, all the growth or gains will be taxed (or tax free in a Roth) due to the type of account as long as you abide by the IRS guidelines.
In a non-retirement account, on the other hand, the taxes can happen at any time. The kind of accounts this would be have many names: joint investment accounts, mutual fund accounts, trust accounts, brokerage accounts, individual investment accounts, non-retirement investment account, and transfer-on-death (TOD) accounts are some of the many. You may even hear the term a “bridge account” since it can bridge the gap in retiring before retirement accounts are without penalty or serve for non-retirement goals as well.
ETF vs Mutual Funds When it Comes To The Type of the Account
In all those different non-retirement account types, an ETF may be more desirable than mutual funds due to the taxability. A mutual fund as it grows can give off more taxes to have to be paid along the way than an ETF in general.
Investing in Index Funds Vs Stocks
When you invest in an index fund, you are owning multiple holdings that qualify to be in that particular index. When you invest in a stock, you own shares of a company. Another item of note is that stock will always represent ownership of the company, where an index fund may own non-stock as well such as cash, treasuries, and bonds.
One way of having both an index approach and owning stock is direct indexing. That is when you build a portfolio of all the stock held in an index and you own the stock instead of the index. It can be more technical, but some of the reasons to consider this would be if you wanted to screen out certain companies or industries and if you also wanted more control around taxes.
The Different Indexes
There are many different indexes, including:
Indexes for a sector of the economy such as oil and gas or biotechnology
Indexes for international markets and world markets.
Indexes for local and domestic markets
Indexes for the capitalization sizes of companies
Because an index is merely a way of screening companies and creating a guideline for inclusion, indexes are created regularly. The more commonly referenced indexes, however, are the ones in which many people choose to invest.
How are Non-Indexed Mutual Funds Different?
A non-indexed mutual fund is also a pooled investment; however, the difference is that the mutual fund manager is tasked in choosing and eliminating companies based on their research and objectives. Example: A mutual fund might be looking at large US companies just like a S&P 500 index fund would, but that mutual fund might only hold 100 companies instead of all 500 because they think those will be the best performing of the group or it’s their mandate to have a certain kind of company included.
Index funds (whether through a mutual fund or ETF), are designed to closely track the index performance.
Non-indexed mutual funds provide you with the ability to over or under perform, unlike an index fund.
Here’s the great thing about choosing mutual funds, index funds, and ETFs – you don’t have to. You can invest in all of them!
The best options for your situation might be to use one kind in one account, and another kind in a different account. Know the differences and have someone walking with you who can explain some of the finer points.
As the Cremé Wealth Team we walk with clients on their retirement journey. Analyzing investments including index funds, mutual funds, and stock are all part of retirement planning and legacy planning. We offer complimentary consultations and are happy to help anyway we can.
Index Funds FAQs
What are S&P 500 Index Funds?
S&P 500 index funds are typically mutual funds or ETFs that are designed to mirror the holdings that are present in the S&P 500 index at all times.
What is an ETF?
An ETF is a pooled investment in a particular group of holdings that are tied to an index or a predetermined screening algorithm.
What is an IRA?
An IRA is an individual investment account which allows you to save and invest a certain amount each year and has the ability to potentially give you a tax-deduction.
What is a 401k?
A 401k is an employer-based defined contribution plan that allows participants to defer some of their compensation into an account that can be invested into select offerings.
What are Stocks?
Stocks represent ownership in a company and a right to a share of the value as well, profits distributed to owners, and voting on certain items.
The information contained in this communication does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Andrew Cremé and not necessarily those of Raymond James. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Past performance does not guarantee future results. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation.
The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance
Every type of investment, including mutual funds, involves risk. Risk refers to the possibility that you will lose money (both principal and any earnings) or fail to make money on an investment. Changing market conditions can create fluctuations in the value of a mutual fund investment. In addition, there are fees and expenses associated with investing in mutual funds that do not usually occur when purchasing individual securities directly.
ETF shareholders should be aware that the general level of stock or bond prices may decline, thus affecting the value of an exchange-traded fund. Although exchange-traded funds are designed to provide investment results that generally correspond to the price and yield performance of their respective underlying indexes, the funds may not be able to exactly replicate the performance of the indexes because of fund expenses and other factors.
Investors should consider the investment objectives, risks, charges and expenses of an investment company carefully before investing. The prospectus contains this and other information and should be read carefully before investing. The prospectus is available from your investment professional.
Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional.
Contributions to a traditional IRA may be tax-deductible depending on the taxpayer's income, tax-filing status, and other factors. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty.
401(k) plans are long-term retirement savings vehicles. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty.
Holding stocks for the long-term does not insure a profitable outcome. Investing in stocks always involves risk, including the possibility of losing one's entire investment.