ETF vs Mutual Fund vs Index Fund - What's Best?

Believe it or not, it’s not as complicated as the jargon-y names make it seem. You just need to understand some basics and determine what your comfort level is in terms of risk, investing fees and how involved you plan to be in your investing. Passive investing is certainly one approach, and it works for many. But others want to be more active and know what their money is doing all the time.

We’re here to help with some investing 101 guidance. We’ll answer some common questions about ETFs (exchange-traded funds), mutual funds, and index funds, then hopefully shed light on which of these investment vehicles makes sense for your young portfolio.

Are ETFs good for beginners?

An ETF stands for an exchange-traded fund which essentially means you can buy a basket of securities (a fund) on an exchange like the TSX (Toronto Stock Exchange), Nasdaq or NYSE. These funds can be made up of many different assets – stocks, bonds, or commodities like gold and silver. They can also be made of stocks from particular sectors, like financial services or technology. When you buy the fund, you buy a share of the basket, but not what’s inside. Make sense?

Here's an example: the Millennial ETF holds stocks in Apple, Tesla, Snapchat, Starbucks, Microsoft, Netflix and many more companies. You can buy shares of the Millennial ETF anytime on the Nasdaq and the share price will rise and fall with the fortunes of these underlining stocks.

Pros & cons of ETFs

These funds can be great for new investors because you can have a set-it and forget-it mentality. Many brokerages will invest in ETFs for you for a relatively low fee. Some brokerages, like Wealthsimple, can do it through automation called “robo-advisors,” which accounts for the low fees. That really smart computer managing your investment needs to get paid for its time. 

The downsides to ETFs are similar to anything else on the stock market – prices might drop and so will your investment. Another consideration is that ETFs are not short-term solutions for gains on your investment. They take time, often around 5 years to see solid returns, and your money will be locked up as you seek that upward trend of the overall market.

What is a mutual fund and how does it work? 

What puts the “mutual” in mutual funds? It’s thousands of investors pooling their money together to invest in a range of stocks, bonds and other assets. They all mutually want to get the best returns. It’s one of the most common investment vehicles available because of the management fees tend to be much higher than, say, ETFs and index funds. 

Why are the management fees higher? It’s because you have an actual human being looking after the fund and trying to beat the market, meaning getting a return better than the average stock market indexes (more on those later). Mutual funds are extremely popular because the average investor doesn’t have the time or money to create a diversified portfolio. They lean on these funds to do that work and bring in a solid yearly yield. 

If you invest in mutual funds, the first question you will need to answer is, how much risk can you handle? Some funds lean heavily on American stocks, which are risky but tend to perform better, while others will lean heavier on fixed income, or better known as bonds. Bonds are generally viewed as much less risky, but don’t yield as much on returns. A balanced combination of the two is a popular route to take.

Are mutual funds good or bad?

If there’s a major strike against mutual funds it’s their top-tier management fees – sometimes called expense ratios. These fees usually range around 2% charged annually as a percentage of your investment. That may not seem like much at first glance, but it can eat into your returns over the long term. And, consider that you will be charged these fees even when your fund has a bad year. The cherry on the cake is that Canada has some of the highest expense ratios in the world.

That being said, high-performing mutual funds can be extremely lucrative. Some of the top mutual funds in Canada last year delivered returns as high as 94%. That’s nearly doubling your money in one year. Of course, those are exceptions. Most mutual funds returned around an average of 10% last year, which is nothing to sneeze at considering a “high-interest” bank account will get you maybe .05% interest on your money.

Are index funds better than mutual funds? 

An index fund is a type of mutual funds with the intent purpose of tracking and matching a particular market index. What is a market index you ask? An example would be the S&P 500, an index of the top 500 largest US companies. Think Amazon, Google, Apple, Bank of America, etc. 

For example, index funds will try to match the performance of the S&P 500, which will usually go up over time as stock markets tend to do. While a mutual fund is working hard to beat the market, and prove worthy of its expense ratio, an index fund is happy to move at a steady upward rate of the overall market. 

This is considered a less risky investment, as these indexes, which include the Dow Jones Industrial Average or the Nasdaq Composite among others, tend to be less volatile than owning individual stocks. Buying into an index fund is like buying the whole market. A diversified investment like an index fund will protect you against volatile swings in certain sectors or failing individual stocks. 

Index funds have gained in popularity over mutual funds because they tend to cost less in fees and can also be managed through automation by “robo-advisors” in a similar way to ETFs. They don’t erode your returns the way mutual funds can, while providing a pretty straightforward investment goal – follow the market as it goes up.

Become the next Warren Buffet with index funds 

Iconic American investor Warren “Oracle of Omaha” Buffet has amassed over $60 billion through his investments over the decades. He is an advocate of index funds because he says individuals are generally not great at picking consistently winning stocks. In other words, you’re not as smart as you think you are, so better to invest in the market as a whole. Buffet says “broad indexes” are the way to go, like an S&P 500 index fund.

Are you an investing beginner? Read more about how you should save and invest your money.