A client asked me the differences among mutual funds, index funds, and exchange-traded funds or ETFs. My goal was to explain the key features, costs and risks that he’d need to understand, says Steve Pomeranz, CFP Thursday. More Trading Lessons Friday on MoneyShow.com.

Let’s move on to Index funds, in the concluding part of this series. The basics of mutual funds here.

John Bogle, the venerable founder of the Vanguard Group, started the First Index Investment Trust in December 1975. His idea was to create a low-cost vehicle which would invest in a basket of stocks representing the entire market. 

Instead of beating the index and charging high costs, his index fund would mimic the index and attempt to match its performance—thus achieving near market returns, with significantly lower costs and fees.

When it was introduced, Bogle’s concept was considered un-American (if you can believe it!) and was widely ridiculed. It was called Bogle’s Folly. 

Needless to say, indexing got off to a very slow start and only gradually picked up steam as institutional investors started to see its potential benefits.  Thereafter, small investors also started to embrace the idea, and before long, the Vanguard S&P 500 (VFINX) fund grew from $11 million to over $403.9 billion (as of May 2018).

If you’re interested in learning more about the early days of the Index Fund, written by John Bogle himself, I’ve included a link here.

Index fund positives

Index funds have a lot of positives, but I’ll cut to the one that really matters.  Index funds offer a low-cost and minimal-trading strategy that can arguably outperform many actively managed mutual funds.

Moreover, innovation has resulted in the indexation of a large variety of markets and industries, giving investors a wide range of fund choices.

Index fund negatives

On the downside, index funds are still mutual funds and contain some of the same drawbacks.  For instance, index funds too are required to distribute taxable annual gains by year-end.  On the plus side though, index funds generally have small distributions, if any, because of their buy-and-hold investing style.

And like mutual funds, index fund purchases and sales are settled at the end of each trading day, exposing you to the possibility of buying in at the top or selling at the bottom of each day’s value.

ETFs: A true modern innovation

Let’s talk about exchange-traded funds or ETFs.

The first ETF was created in 1989, in an attempt to correct some of the drawbacks of mutual funds.  Unfortunately, a federal court deemed this early ETF to be more akin to a futures contract than to a security, so it was quietly quashed. But the basic idea of an ETF was too powerful to ignore.

It took another four years, until January 1993, for the very first ETF to get listed in the U.S.  This was the infamous SPDR S&P 500 Trust (SPY) which was designed to replicate the price and yield performance of the S&P 500 Index (SPX).

ETFs gained in popularity because they offered structural innovations that corrected some of the deficiencies of mutual funds.

ETF positives

ETFs are not required to pay distributions from capital gains at the end of each year.  Instead, the ETF holder only incurs a capital gain or loss on selling the ETF.  So, this gives investors control over when to take capital gains and losses.

Unlike mutual funds and their end-of-day settlement drawback, ETF shares are traded continuously through the trading day, so you know exactly what price you are getting at the moment of sale.

Like stocks, ETF investors can borrow against the value of their shares and trade on margin if they wish to and be shorted, if a speculator wants to bet against the market.

ETF negatives

Now to the negatives of ETFs.

Wall Street has witnessed an explosion in the number and types of ETFs available to investors. Some ETFs go up when the market goes down and some go down when the market goes up. And some go up or down two or three times as much on a given day.

Also, ETFs will fluctuate with changes in market conditions and are not suitable for all investors. Since ETFs trade like stocks, they are subject to brokerage fees and trading spreads. Therefore, ETFs are not effective for dollar cost averaging small amounts over time.

ETFs do not necessarily trade at the net asset values of their underlying holdings, meaning an ETF could potentially trade above or below the value of the underlying portfolio

So, while some ETFs can be very risky and charge higher than average fees, there is a universe of over 2,000 ETFs that track every sector, region, and asset class and build a well-diversified portfolio.

Vanguard's Bogle has never seen market volatility like this (April 2018).

Wrap Up

So, to wrap up, a mutual fund’s founding idea of pooling your assets with others is a tremendous opportunity to investors and our economy.

And the argument on active versus passive strategies will continue for some time, with some worrying that a market controlled by passive investors may not be able to identify or reward good companies, while others may believe the market will find a way.

If simplicity and low fees and expenses are important to you, then you may find index funds to be more appealing. ETFs have the same but can be a lot riskier if you’re not careful.

I know this profusion of choice—between mutual funds, index funds, and ETFs—can be confusing, so before you randomly select something, do a fair amount of research.  Or, better yet, consider having an advisor help you pick a combination that’s right for you.

Last of this 2-part series. 

To find out more, go to www.stevepomeranz.com