Guides · Markets & investing
Funds: Mutual, ETF, Index
Buying 500 stocks individually would cost a fortune in effort and fees. Funds solve that by pooling money. The differences between the types are small, boring, and worth thousands of dollars.
Two questions, not one
Every fund answers two independent questions, and running them together is the single most common confusion in investing.
The first is the wrapper: how you buy it. A mutual fund is priced once a day after the close, at net asset value — everything it holds, divided by shares outstanding. Order at 10:30am and you get that evening's price, whatever it turns out to be. An ETF trades on an exchange all day like a stock, so you see the price before you commit.
The second is the strategy: what it does with your money. An index fund tracks a published index and makes no judgement calls; an active fund pays a manager to pick holdings and try to beat a benchmark. The two questions are independent — index mutual funds, index ETFs, active mutual funds and active ETFs all exist. When someone recommends 'an ETF', they have told you about the wrapper and nothing about the strategy.
Mutual fund / ETF is how it trades. Index / active is what it does. Neither implies the other.
The cost you never get a bill for
The expense ratio is the percentage a fund takes each year, deducted from the fund's assets before your return is calculated. No invoice ever arrives and no line item appears on your statement — the return you see is simply the return after the fee.
Because it comes out every year, it compounds against you exactly as returns compound for you. Take a $10,000 investment that earns 7% a year before fees for 30 years. Charged 0.03%, it grows to about $75,500. Charged 0.65%, it grows to about $63,400.
The gap is roughly $12,000 — more than the original investment — from a difference of about six tenths of one percent. That is why this unglamorous number gets so much attention: it is one of the few things about a fund you can know in advance and control completely.
What owning 500 companies does and doesn't fix
A fund holding 500 companies makes any one of them nearly irrelevant to you. If one commits accounting fraud or goes bankrupt outright, it was a fraction of a percent of your money. That is idiosyncratic risk — specific to one company — and diversification genuinely eliminates it.
What it cannot touch is the risk they all share. A recession, a rate shock, a credit freeze: these move everything at once, and owning more of everything does not help. That is systematic, or market, risk.
Through the 2007–2009 crash the S&P 500 fell about 57% peak to trough — about −37% in calendar 2008 alone — because 500 different companies fell together. Diversification protects you against being unlucky. It does not protect you against being invested.
Mutual fund and ETF describe the wrapper — how it's priced and traded. Index and active describe the strategy. Any combination exists, and the strategy is where the fees are.