ETFs, mutual funds and index funds: what they are and how they differ

The idea

Instead of picking individual companies, a fund pools many investors’ money and holds a basket of securities. You own a slice of the basket. That gives instant diversification at a low entry cost.

Mutual fund

A mutual fund is priced once a day, after markets close. You buy or sell at that day’s price. Some have minimum investments, and active ones employ managers who try to beat a benchmark, usually charging more for it.

ETF (exchange-traded fund)

An ETF holds a basket like a mutual fund, but its shares trade on an exchange all day like a stock, so you can buy a single share or a fraction with a brokerage account. Most ETFs track an index and have low fees. ETFs hold many securities but trade like one.

Index fund

An index fund is any fund, ETF or mutual fund, designed to match an index such as the S&P 500 rather than beat it. This “passive” approach keeps costs low. The alternative is “active” management, where a manager chooses holdings; research has repeatedly found that most active funds fail to beat their benchmark after fees over long periods, although a few do.

Comparing them

• Expense ratio: the annual fee as a percentage of your holding. 0.03% costs $3 a year per $10,000; 1% costs $100. Over decades that gap compounds.
• What it holds: look at the top holdings and sectors. Two funds with similar names can hold very different things.
• Overlap: owning several funds that hold the same companies is not diversification.
• Trading: ETFs have a bid-ask spread; mutual funds do not but may have minimums or transaction fees.

How to invest in them

• Open a brokerage account, or use the funds offered inside your employer retirement plan.
• ETFs: search for the ticker, choose an order type and a number of shares or a dollar amount if fractional shares are offered.
• Mutual and index funds: enter the fund name and an amount; the order fills at the day’s closing price.
• Set up automatic recurring purchases so you invest on a schedule.

Target-date funds

A target-date fund picks a retirement year and gradually shifts from growth assets to safer ones as that year nears. It is a one-decision option, though fees and the exact glide path vary between providers.

ETF or single stock?

Neither is “better”. A stock is concentrated risk and potential in one business. An ETF spreads risk. Many investors hold mostly funds and, if at all, a small share in individual companies.

Before holding any fund, read its fact sheet: holdings, fees, what it tracks, and how long it has existed.