Mutual Funds and ETFs
Active funds, index funds and ETFs – how they work, what they cost, why most active funds fail to beat their index and what to look for when choosing an ETF.
Key takeaways
- A fund pools money from many investors and invests it under fixed rules. Its assets are held separately and protected if the fund company fails.
- An ETF is an exchange-traded fund, usually tracking an index – diversified, transparent and cheap.
- Most active funds trail their benchmark after fees over long periods. Costs are the most reliable predictor of fund returns.
- Key criteria when picking an ETF are the index, the expense ratio, tracking difference, fund size, liquidity and – depending on where you live – tax structure.
- In the US, ETFs are often more tax-efficient than mutual funds. In Europe, investors choose between accumulating and distributing share classes.
Anyone investing for the first time faces a dilemma: single stocks are risky, and diversifying properly would take dozens or hundreds of them. Funds solve exactly that problem. And one type of fund – the ETF – has changed the way millions of people invest over the past twenty years.
How a fund works
An investment fund collects money from many investors into one big pot. A fund company invests that pot according to set rules – in US large caps, say, or in corporate bonds. Each investor owns fund shares and therefore a slice of everything the fund holds.
That brings three big advantages:
- Diversification with small amounts: With $50 a month you can own pieces of hundreds of companies.
- Professional administration: Buying, selling, dividends, corporate actions – the fund handles it.
- Legal protection: Fund assets are held by an independent custodian, separate from the fund company’s own money. If the company fails, the assets still belong to investors.
Active or passive?
There are two philosophies for how a fund invests.
Active funds are run by a manager who tries to beat the market by picking stocks. That costs money: expense ratios of 0.5% to over 1% a year are common for active stock funds, and some still charge sales loads.
Passive funds or index funds don’t try to beat the market. They simply replicate an index – the S&P 500, for example – and hold every stock at its index weight. That takes little effort and is correspondingly cheap: broad index ETFs often cost 0.03% to 0.20% a year.
The uncomfortable statistics
Surely a skilled manager is worth it? The data are clear. S&P Dow Jones Indices publishes regular SPIVA reports comparing active funds with their benchmarks. Over 15 years, in virtually every major stock category – US and international – the large majority of active funds, typically around 85–90%, underperform their index.
The reason is simple arithmetic. All investors together are the market. Before costs, they earn the market return on average. After costs, they earn less – by exactly their costs. Pay less and you keep more. Nobel laureate William Sharpe called this “the arithmetic of active management” in a famous 1991 paper.
ETFs: funds that trade like stocks
ETF stands for exchange-traded fund. An ETF is legally a fund, but it trades on an exchange all day like a stock. Most ETFs are passive index funds, although actively managed ETFs have grown quickly.
What keeps an ETF’s market price from drifting away from the value of its holdings is a clever mechanism. Large dealers called authorised participants can create new ETF shares at any time by delivering the underlying securities to the fund – or redeem shares and receive securities back. If the ETF trades above its net asset value, they create shares and sell them; if it trades below, they buy shares and redeem them. That arbitrage keeps the price tightly aligned with the fund’s value.
How to choose an ETF
| Criterion | What it means |
|---|---|
| Index | The most important decision: which market do you want to own? Total US market, world, a region, a sector? |
| Expense ratio | Running cost per year as a percentage of assets, deducted automatically. |
| Tracking difference | The actual gap between the ETF’s return and the index – the honest cost figure. |
| Fund size and volume | Larger, heavily traded ETFs have tighter spreads and are less likely to be closed. |
| Structure | Physical replication (holds the stocks) or synthetic (uses swaps); for Europeans also domicile and accumulating vs. distributing. |
Accumulating or distributing? (For European investors)
European UCITS ETFs come in two flavours. Accumulating share classes reinvest dividends inside the fund; distributing ones pay them out. Before taxes, the returns are equivalent; tax treatment depends on your country. US ETFs always distribute dividends, which you can reinvest automatically through your broker.
The simplest starting point
For most investors, a broadly diversified total-market or world ETF, bought regularly, is a very solid foundation. It spreads money across thousands of companies, countries and sectors, costs little and requires no individual picks. What it can’t do is avoid swings: a stock ETF falls in a crash just like the market it tracks. Module 3 shows how to balance that with bonds or cash.
Summary
Funds pool many investors’ money and allow broad diversification with small amounts, with assets protected from the fund company’s creditors. Active funds try to beat the market and mostly fail after fees. ETFs track indices cheaply and transparently and trade like stocks. When choosing, focus on the index, the costs and the actual gap to the index.
Time to practise
13 short exercises on this lesson – mistakes come back at the end. Then the lesson is complete and joins your review queue.
Test your knowledge
0/401An active fund charges 1.0% a year, an index ETF on the same market 0.05%. What must the manager achieve for the active fund to be worth it?
02What happens to your ETF if the fund company goes bankrupt?
03Which figure best shows how much return an ETF actually loses relative to its index?
04Why are US ETFs often more tax-efficient than US mutual funds?