Index Fund vs ETF vs Mutual Fund and the #1 thing new investors get confused with when comparing these. A beginners guide on the differences between them and which is the best to use for each situation. Pros and cons of using index funds vs ETFs (exchange traded funds) vs mutual funds (managed funds).

Easy to understand video on index funds for beginners, ETFs for beginners, and mutual funds for beginners. Detailed explanation on the differences/similarities and pros/cons of index funds vs mutual funds vs ETFs!

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Common Benefits of Index Funds, ETFs and Mutual Funds

All of these funds offer two major benefits: the first is convenience. By investing in a Mutual Fund, Index Fund or ETF you get to own a bunch of different companies all in one easy package. One of these funds could have thousands of different individual stocks in it but you only have to make one purchase to own a portion of all of them. In a world without funds, if you wanted to have say a thousand different stocks in your portfolio you'd have to make 1000 separate purchases. If you’re paying $10 per trade that would cost you $10,000 alone just buying the companies, it would also take you a lot of time! However depending on the fund you chose you would either pay nothing to enter the fund or just pay a one-time fee. This is way simpler than trying to self-manage a portfolio of thousands of different companies, constantly trying to re-balance weightings every day.

Through owning a lot of different stocks this gives you the other major benefit of these investment funds, that is diversification. Like even if you have 10 individual stocks in your stock portfolio if one of those goes down and fails you can end up losing a lot of money. On the other hand if you go and buy the entire S&P 500 index fund, then you have 500 different stocks and different companies that contribute to your overall return. So even if one of those fails it doesn't really matter because you have 499 others to boost you up.

Mutual Funds
So I’ll start with mutual funds which were the original investment fund out of these 3 types and have been around the longest. A mutual fund is a type of investment product where the funds of many investors are pooled into an investment product. The fund then focuses on the use of those assets on investing in a group of assets to reach the fund's investment goals. Now it’s important to note here, by pure definition a mutual fund can actually be either an actively managed fund or a passive index fund, but industry-wide it’s widely assumed when someone is referring to a mutual fund these days, they are talking about an actively managed fund and for simplicity's sake I will be using the same assumption when talking about mutual funds now.

Index Funds
Moving on to Index Funds which are actually a type of Mutual Fund that were born out of the desire for low fee passive index tracking funds, and this created the Index Fund. Like the name suggests, Index Funds are always passively tracking an index. If you don’t know what an index is: it’s a method to track the performance of some group of assets in a standardized way. Indexes typically measure the performance of a basket of securities intended to replicate a certain area of the market. These may be broad-based to capture the entire market such as the Standard & Poor's 500 (S&P 500) or Dow Jones Industrial Average (DJIA), or more specialized such as indexes that track a particular industry or segment. Indexes are also created to measure other financial or economic data such as interest rates, inflation, or manufacturing output.

Exchange Traded Funds (ETFs)
Moving onto ETFs which are the newest form of these 3 investment funds, ETF stands for Exchange Traded Fund and this is exactly what it is. An ETF is a fund that, instead of buying into their fund through bank transfers, you can purchase portions of the fund directly on a stock exchange. If you want to know more about ETFs in particular check out my in-depth guide on getting started with ETFs.