Welcome to Clo Bare’s Investing 101 series where we’ll cover the basics of investing to build wealth. Investing can be incredibly confusing if you’re a noob entering into the world of Exchange Traded Funds, Index Funds and Mutual Funds– not to mention just basic stocks and bonds. Seems like a lot to remember, right? And who wants to put their money in something they don’t fully understand? I feel you. That’s why I’m going to break it down in this series, starting with this post on ETFs, Index Funds and Mutual funds.
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Investing can be confusing as hell.
I spent most of my life assuming I’d never learn about investing because I figured I’d just wing it. After all, that’s what financial advisors are for, right? I’d just get one of those eventually.
But slowly things started to change.
And that led me to learn about debt payoff.
And then I learned about this thing called early retirement.
AND THEN I fell into the never-ending spiral of fun that is the Financial Independence Retire Early community.
As I continued to learn, I realized I couldn’t avoid investing forever and it really wouldn’t be a good idea for me to leave my future and my hopeful wealth in the hands of someone else.
So slowly but surely, I started learning about the stock market and how to invest in a way that made sense for me.
Fast forward two years later, and not only do I invest, manage my own portfolio and know the difference between mutual funds and index funds– I also teach folks about it.
The Good News? If I can Learn How to Invest– Anyone Can.
If I can learn it? The girl who once cried over her math homework because it was too hard and didn’t make it past Pre-Calculus? The woman who studied English and Spanish and college and took logic instead of another Math class just to get the credit she needed?
If I can learn it, I’m pretty sure you can learn it too, my dude. And I’m here to make this a gentle process, easy to understand, and hopefully a little bit entertaining.
Cool. Let’s do this.
In this post, we’re going to cover the basics of three types of investment funds– mutual funds, index funds and exchange-traded funds.
A Note on Funds
Now, before we begin, please note– the three different types of investments I discuss in here are funds– not individual stocks, bonds or other securities. I’ll do another post on those another time.
When you purchase a fund, you are not purchasing an individual stock. Instead, you are purchasing an entire portfolio filled with stocks, bonds and whatever other financial assets reside within the fund. How the fund does and what value it provides depends on how all the stocks, bonds and other securities within it perform.
This gives investors instant diversification– meaning you didn’t put all your eggs into one basket. So if one stock within the portfolio does bad– well, you have 99+ other securities in your portfolio to even out that blow. If instead of purchasing funds you decided to purchase stock from only ONE company, putting all your eggs in to that basket, and that one company fails– welp, you’re screwed and there goes all your money.
The types of funds we discuss in this post are nice because they provide a cushion in case any of the investment assets fails.
Funds Vs. Stocks as Chocolate Analogy
Think about it this way– a fund is like a box of chocolates and a stock, bond or other financial asset is a chocolate bar.
When you purchase a fund, you buy the whole box of chocolates that contains many different stocks, bonds and other assets within it (ie some strawberry creams, some caramels, some choco-covered nutes, etc). You can’t pull out different assets from the box of chocolate, either. You have to buy the box as a whole and that means even if there are chocolates in there that you don’t like.
Conversely, when you purchase just one stock, you’re only buying one candy bar. If you haven’t tried that candy bar before, you’re risking satisfying that craving because you only have one chance for it to be the candy you need! What if you don’t like it? What if it doesn’t quench the craving?
Welp, better hope it does because you’ve blown the candy budget on one bar. With a chocolate box, there’s less risk because there are several different types of chocolates so likely at least one will satisfy your chocolate craving.
Make sense? A fund has many things in it and when you buy a fund, you buy all the things in it.
Now, let’s start with mutual funds.
What is a Mutual Fund?
A mutual fund is an investment product run by a company that pools money from many investors and then invests that money into tradable financial assets such as stocks, bonds and other tradable securities. Basically–they take some of your money, some of my money, some of Joe’s, and we all go in together to put together a portfolio that we a little bit of.
These funds are operated by professionals– think top of the line, went to Harvard, studied finance level professionals– who essentially buy, sell and trade with the pool of money from the investors in order to make the most money possible for the investors. Basically– they decide where the money goes and as an investor– you’re trusting them to make the best decisions with your money in hopes that they’ll make you more money.
With mutual funds, there are actively managed mutual funds and passively managed mutual funds, which are called Index Funds. We’ll talk about those later. This section is about the actively managed mutual funds.
Why Do Mutual Funds have Money Managers?
Essentially, these professionals, called money managers, aim to “beat the market”.
What does “beat the market” mean, you ask?
“Beating the market” means having a fund that outperforms what the ENTIRE market performs in a year. Over the last 100 years, the market, on average, returns about 7-8% annually, when adjusted for inflation. These money managers, what to make MORE than that 7-8% return for their investors so that investors keep hiring them to manage their investments.
The idea behind having a professional manage a fund for an investor is that they are the best and brightest minds, who’ve studied the stock market for years working hard to make the most money possible for the investor. In short– they “supposedly” have a better chance than the average investor at “beating the market” because of their experience, studies and specializations.
How is Money Made in a Mutual Fund?
There are three ways mutual funds make money.
- Dividends on stocks and interest on bonds held in the funds portfolio: A dividend is like a thank you from a company to investors for holding their stocks. Not all investments have them, but when buying a stock or fund, this information should be readily available. These dividends get paid out to investors once a year (sometimes quarterly or more) and investors usually get the choice to get a check from the mutual fund or reinvest the earnings in the mutual fund.
- Selling funds: Investors can also sell mutual fund shares when they go up in price, making a gain in the difference between when they bought the fund and when they sold it.
- Capital Gains: If one of the stocks, or other securities within the fund increases in price, this is called a capital gain. Most funds will pass these gains on to the investors.
Mutual Fund Fees
One important thing to keep in mind about mutual funds is that having access to a professionally managed fund and instant diversification comes with a hefty price tag. Mutual funds come with annual operating fees that are usually ranging from 1-3% of your portfolio. There are also shareholder fees which occur when an investor purchases or sells a fund.
The Benefits of Investing in Mutual Funds
1) Professional Management
Some folks like that mutual funds are run by “experts”. You know the people running the mutual fund are top of the line and they’ll do all the research for you so you don’t have to become a day trading expert. Is there truly a benefit to having a professional manage your account? We’ll cover that more in the drawbacks section.
As we mentioned before, you’re not putting all your eggs in one basket. Usually a single mutual fund has 100+ assets in it so if one fails, you’re cushioned pretty well by all the other assets.
3) Opportunity to Outperform the Market in the Short Term
Mutual funds have an opportunity to outperform the market in the short-term. In the span of one year, 30% of large-cap mutual funds outperformed the market while 70% of mid-cap mutual funds beat the index in the course of a year. So if you’re looking to more actively manage your investments in order to make a lot of money– mutual funds are the way to go.
Fees aside, mutual funds are pretty affordable if you compare it to purchasing each asset within the fund yourself. It would be extremely unaffordable to purchase the 100+ stocks in a mutual fund on your own. Mutual funds allow you to buy pieces of all the different assets in the portfolio for one price.
Drawbacks of Investing in Mutual Funds
1) Hard to Beat the Market
Despite the high fees investors pay for professionally managed mutual funds, it is extremely tough to beat the market. In fact for the last ten years, Index Funds have outperformed actively managed mutual funds. Index Funds, which we’ll go into later in this post, are a low-cost alternative that ALSO outperform mutual funds so the question is– what’s the point in paying the high fees of a mutual fund if the hired professional can’t actually beat the market? I suppose there’s always a chance that the money manager will be able to somehow beat the market, but in the last 15 years, 92% of actively managed funds have performed worse than the index. Hmmmm.
2) Actually Expensive AF
Mutual funds come with annual operating fees that are usually ranging from 1-3% of your portfolio. There are also shareholder fees which occur when an investor purchases or sells a fund.
These funds are expensive and most of the time– they aren’t worth the cost. The thing is, the hired professionals who manage these accounts have to get paid even if the fund loses money in any given year. Can you imagine paying your fund manager thousands of dollars every year to continue losing money for you?
No, thanks. If you ARE looking into mutual funds, be sure to get a full picture of the money you’ll be paying on fees especially because it differs greatly from fund to fund.
3) Minimum Investments
Getting started in investing in Mutual Funds can be rough only because there are minimum investments that can be a few thousand dollars.
What is an Index Fund?
Index funds are passively managed mutual funds designed to perform according to a certain index, such as the S&P 500. While all index funds are mutual funds, not all mutual funds are index funds. Usually, you’ll know if the fund is an index fund because it’ll have “index” in the title.
Just like the mutual funds we described above, index funds pool money from multiple investors to buy stocks, bonds, and other securities that make up the portfolio. Because it’s a mutual fund when you purchase an index fund you purchase several financial assets for one price.
Again, like mutual funds, you don’t pick out individual stocks because the stocks have already been picked for you within the fund.
Remember the box of chocolates? You’re getting all those flavors with one price.
What’s in an Index Fund?
Because these funds have been constructed to match an index, there isn’t a lot of buying or selling happening in the fund, which means it’s passively managed. These funds are designed to be the market, not beat the market, meaning they buy every stock listed in a certain index.
For example, the S&P 500? An index fund designed to mirror the performance of the S&P 500 will buy all 500 of the companies’ stocks in the same proportion that is represented in the market.
And because index funds are passively managed and there’s way less work to maintain an index fund, fees are much lower than actively managed mutual funds.
And, like, a lot lower.
Remember how I said mutual funds have an expense ratio of 1-3%? Index funds usually have an expense ratio closer to 0.2% to 0.5% and even as low as .03% or Free.99! That may not seem like a huge difference, but when we’re talking about hundreds of thousands of dollars it adds up:
$500,000 x 3%=$15,000/year
$500,000 x .5%= $2,500/year
I mean… which one would you rather pay out of your retirement?
How is Money Made in an Index Fund?
Investors make money from Index Funds pretty much the same way they do with mutual funds:
- The price of the index goes up– and so does the value of the investor’s shares of the index. These are called capital gains.
- Dividends: Same as mutual funds– these are the thank you notes with money you receive for holding the fund.
- Selling funds: Investors can also sell index fund shares when they go up in price, making a gain in the difference between when they bought the fund and when they sold it.
Benefits of Investing in Index Funds
With Index Funds, you’re buying the whole market. Just like an actively managed mutual fund, you get instant diversification. No need to worry about picking out individual stocks and bonds or other assets– instead you can rest easy knowing you’re invested in a variety of industries with one simple index fund. This helps cushion the blow if one company isn’t doing well because you have 99+ more that will hopefully keep performing. This minimizes the risk of you losing all your money in the stock market.
They is low-cost AF. Fidelity ZERO Large Cap Index (FNILX) was voted the number one Index Fund in September 2020 by Bankrate.com and it has a 0% expense ratio. 0%! It doesn’t get cheaper than that.
3) No commissions on individual stock purchases or sales.
Again. Low-cost, which means more of your money is spent earning more money in the market instead of funding a professional to manage your investments.
4) Long-Term Returns Outperform Actively Managed Funds
I’ll say it again: in the last 15 years, 92% of actively managed funds have performed worse than the index. That means only 8% of actively managed funds outperform the market which means that the other 92% paid for a service that cost them money instead of making them money. For the long-term, they definitely outperform actively managed funds but on the flip side, in the short term, actively managed funds tend to outperform the market.
5) Easy AF
Using index funds as your long-term investment strategy is easy AF. You just buy and hold. Pretty much every brokerage has index funds you can purchase. It’s easy to identify because they almost always have “index” in the title of the funds. And that’s it! No trading, no monitoring the market, no doing research. Just buy and hold.
Drawbacks of Investing in Index Funds
1) No Flexibility
There are no adjustments you can make within an index fund. For example, if a stock within the fund starts plummeting, there’s no ability to panic sell and try to buy something that is performing better. Index funds follow the market index, including the good and the bad.
2) Limited gains.
On the flip side of outperforming actively managed funds, Index Funds are not designed to beat the market. They are an exact representation of the market, so what does that mean for your gains? They’ll never be better than the market returns.
3) Minimum Investments
Getting started in investing in Index Funds can be rough only because there are minimum investments that can be a few thousand dollars.
What is an Exchange-Traded Fund (ETF)?
ETFs and Index Funds are both passively managed investment buckets designed to mimic the performance of another asset. They’re kind of like combining the best of both worlds between stocks and mutual funds– they’re already diversified and you can buy and sell as you please.
The main difference between ETFs and the funds we’ve mentioned above is that ETF’s are more like stocks than mutual funds. They’re highly liquid and can be bought and sold like stock shares throughout the trading day, which is something you can’t do with actively managed mutual funds or index funds. Mutual funds and index funds are only bought and sold once a day.
People can and do day trade ETFs, which isn’t the case for mutual funds and index funds. Like stocks, ETF prices fluctuate constantly. They can also track more than just an index– they can track a fund or a commodity or another fund.
ETFs are also managed by a fund provider, but, similar to index funds, they are designed to monitor a market or commodity which means they are low-cost because there isn’t a lot of buying and selling happening within the fund.
How do ETFs Make Money?
ETFs make money the same way mutual funds and index funds make money– through dividends, capital gains, and buying/selling.
Benefits of Investing in ETFs
1) Low Cost
ETFs are passively managed just like Index Funds which means you have lower costs! Woo! For example, an actively managed mutual fund fee is usually about 1-3% of your portfolio plus fees when you buy and sell; Index funds can be as low as 0% to .5%, and ETFs can be as low as 0.03%.
2) Immediate Diversification
Like the other funds mentioned above, these are baskets of securities that will prevent you from putting all your eggs in one basket.
3) Liquid/Trades Like a Stock
Just like stocks, ETFs can be bought and sold throughout the trading day. That’s a benefit and a drawback– benefit because if you want to actively manage your ETF trading, then you might be able to make some quick cash. Drawback? Your ego might convince you that you can beat the market long-term AND it encourages that betting/gambling behavior that doesn’t work out so well in the long-run.
4) More Tax-Efficient
Usually, ETFs don’t make as many gains for investors as actively managed funds, which if you’re trying to not pay taxes a lot of taxes on your gains– is great. When an ETF buys or sells shares, that’s considered an in-kind redemption which means that you’re not going to get any additional tax charge. This differs from mutual funds because if a manager buys and sells within the fund, any capital gains will be distributed to investors if the manager sells for a profit. What does that mean? It means that if your manager makes money for you, you have to pay taxes on that isht. You won’t have that issue with ETFs.
Investing in ETF Drawbacks
1) Encourages Gambling Behavior
Now, this doesn’t apply to everyone but when you can trade stocks and ETFs all day just hoping for that quick fix of cash? That usually leads to an inflated ego and increased gambling behavior which in the long-run, doesn’t do so great. Remember that bit about Index Funds outperforming 90%+ of the market? That’s from buying and holding, not buying and selling every day.
2) May be More Expensive
Technically, ETFs are lower-cost than mutual funds and a low-cost option to invest relatively safely, BUT if you compare trading and selling stocks– technically you’d be paying more than if you’d buy and sell stocks because there is a management fee. Also, when you compare ETFs to Index Funds, sometimes brokers charge commissions for trades (which Index Funds do not) and you’ll incur a fee every time you buy or sell.
Investing 101: Mutual Funds, ETFs, and Index Funds Side By Side Comparison
- Can be actively managed or passively managed
- Actively managed come with expense ratios of 1-3%
- Can outperform market in short-term
- More hands off
- Usually a minimum investment that can be a few thousand dollars
- Passively managed
- Low fees- some even free funds
- Long-term outperforms actively managed mutual funds 90%+ of the time
- More hands off
- Designed to mimic an index
- Usually a minimum investment that can be a few thousand dollars
- Passively managed
- Low fees
- Buy and sell like stocks
- More hands on
- Designed to mimics a market, index or industry
- No minimum investment
Investing 101: What do I do now?
Now, I know this is a lot of information, so you’re probably thinking– Clo Bare, what in the hell do I do with this information?
If you’re at the start of your investing journey, this might be one of your first introduction to the topic and different kinds of investing out there. Your learning is just starting. Spend a bit more time learning about the different options that are out there for you. The more you know, the more you’ll be able to make an informed decision on how you want to invest.
Remember– there’s not ONE perfect way to invest. There’s just the best way to invest for you.
For me, that’s Index funds and real estate right now. For you, that might be mutual funds and ETFs. Take some time to learn in order to find out what’s best for you and your priorities.
Disclaimer: Clo Bare, LLC is not a financial advisor or service. This information is for educational and entertainment purposes only.