Here’s What You Should Know About Mutual Funds, Index Funds, and ETFs

Funds come in all shapes and sizes, and that means there's an investment option that's right for just about every investor. Figuring out when it makes sense to invest in a mutual fund, ETF, or individual stocks can be tough, though, so host Kristine Harjes and Motley Fool contributor Todd Campbell decided to tackle the issue on this week's episode of The Motley Fool's Industry Focus: Healthcare.

In the show, the two Fools explain the ins and outs, do's and don'ts, and pros and cons of funds so you can decide if they're right for you.

A full transcript follows the video.

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This video was recorded on May 2, 2018.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. We're talking Healthcare today, May 2nd. I'm your host, Kristine Harjes. My usual guest, Todd Campbell, is back from a trip to Mexico and calling in, although I bet you'd probably rather be unpacking right now. Todd, how was your trip?

Todd Campbell: It was wonderful! It's great to be back on the show after a fantastic week spent down in a small town called Ajijic, Mexico, which is about an hour south of Guadalajara, right on Lake Chapala. I'll tell you, some of the most gracious people, and wonderful food and a fantastic climate. It's right in the mountains, and it's just beautiful there.

Harjes: Sounds lovely! What was the best thing you ate?

Campbell: Oh, boy! Funny thing -- my son was there, and my son loves Italian food. And you wouldn't think you'd go to Mexico to get good Italian food. There was this wonderful Italian restaurant. [laughs] I couldn't believe it. But, that was his favorite. I don't know. They do wonderful steak. I probably could have gone to a different restaurant for lunch and dinner for a month. There are so many great little places throughout.

Harjes: That awesome! That cracks me up, about the Italian restaurant. That's globalization right there.

Campbell: Right! Right, exactly. And world-class desserts, world-class food. There's one place in the center of the village where they have a square where you can go and sit and have a fantastic cup of Mexican coffee and just watch all the kids playing their games in the square. It was really neat to go somewhere else, where English isn't the first language, and you kind of have to muddle your way through it and figure it all out. But, yeah, it was a great time!

Harjes: That sounds like an awesome experience. We're also glad to have you back! As our regular listeners know, you can reach out to our show via our show email address, Lately, we've received quite a few emails about investing in funds. Particularly, people were wondering about some particular healthcare ETFs. These emails really did disproportionately come into the Healthcare show, which is why I feel justified in using a Wednesday edition of Industry Focus to talk about this topic.

After doling out a bunch of fund investing advice to multiple different emails, I figured there were probably enough people out there with similar questions that we should just do a show about it. Today, we'll be talking about investing in all sorts of funds, starting with some of the basics and a little bit of history, and then we'll get into strategy. Sound good to you, Todd?

Campbell: Yeah. I think this is going to be a really good show, as far as being able to help people who are either relatively new to investing or trying to figure out different ways to spread their money out in their portfolio.

Harjes: Absolutely. First definition I want to throw out there is an index fund. Todd, can you define that for me?

Campbell: An index fund doesn't pick and choose individual stocks to hold in a portfolio. Instead, what it does is, it holds all of the stocks or bonds or whatever happened to be in an index. It tracks an index. Which, of course, raises the question, what's an index? Well, an index is basically a list of investments that's put together by some independent third party. Probably the most famous or well-known of those indexes is the Dow Jones Industrial Average.

Harjes: Yeah, absolutely. As you mentioned, there are a ton of different types of index funds. You can get a broad market fund like the Dow Jones Industrial Average. You can also get global or international funds. You can get sector-specific funds, which, that's a lot of what people were asking about in emailing us, to ask about healthcare index funds. There are also bond funds, as you mentioned. They're a really great way to give yourself exposure to specific parts of the market, or the entirety of the market, in a very low-cost way.

Campbell: Right. One of the most important ones, Kristine, that we always reference back to whenever we're on the show talking about the relative performance against the S&P 500 Index. That's probably the one that's tracked the most, that most people would theoretically want to own in their retirement accounts or whatever, where you have 500 of the biggest U.S. companies that are listed and tracked by these index funds. Then, in that index, you can split it up into the individual baskets. For example, healthcare, or finance, or energy, if you wanted exposure simply to the index of that particular group.

Harjes: Yes. So, when you go about choosing an index fund, you can choose to invest in either a mutual fund or an ETF. We're going to define both of those. A mutual fund pools together investors' money into a giant megaportfolio that's managed by a professional. It can be purchased and sold only at the end of the trading day, and its price is based on the net asset value, which is the value of all of the fund's assets minus the liabilities, you divide it by the number of shares.

Now, mutual funds can be either actively or passively managed. So, if you have a mutual fund that's an index fund, that's generally going to be a lot lower cost, because all it's doing is matching the index that it reflects, as opposed to the actively managed funds in which you're paying a fee toward a professional to actively curate the contents of that megaportfolio and try to beat the market that way.

Campbell: Right, and there's pluses and minuses to that. We'll get into them, I'm sure, later in the show. But, you can have actively traded healthcare mutual funds, or you can have these passive healthcare funds that, say, track the S&P 500 Health Care sector.

Harjes: Yeah. So, one last definition for now would be ETF. That's an exchange traded fund. They're more similar to stocks than mutual funds are because they're traded like stocks. You can trade them throughout the day, much like you would trade an individual security. The value of the ETF really depends on what investors think the underlying value is. Typically, the holdings will be disclosed daily, as opposed to, in a mutual fund, an active mutual fund will typically disclose its holdings on a quarterly or even semi-annual basis. So, things move a lot quicker with an ETF. You get people trading it day in and day out, and you know exactly what's in it every single day.

Campbell: Right. There's also some advantages to that. You have the inter-day portability of it, you can buy or sell whenever you want to, but you're also able, theoretically, to buy it with any brokerage account for any amount of money that you have to invest. A lot of times, mutual funds, you have to put up a certain amount of money to be able to buy into a particular mutual fund, maybe $2,500 or $3,000. Meanwhile, maybe you could get a brokerage account with $500, open it up, and start with ETFs.

Harjes: Yeah. So, really, all of this came to prominence in the mid-1970s with a guy named Jack Bogle, who founded a company that many of our listeners will be familiar with called Vanguard. His whole principal there was, you should be able to get exposure to a big basket of stocks at a very low cost. This is something that I think we take for granted today, but it really didn't exist at that point. What Jack Bogle did was absolutely revolutionary.

I was part of a trip to Philly recently to go meet Bogle at Vanguard, and I have to say, I was a big fan prior to meeting him, but in talking to him, that man is so sharp. He's 88 years old, and he's still so, so smart. He knew exact dates from back in the 70s when different things were happening. I was overall extremely impressed with them.

The company is colossal. They have $5.1 trillion in global assets under management. They offer 180 different U.S. funds. They have 208 additional funds outside of the United States. That reaches 20 million investors across 170 countries. And -- and here's the most impressive stat to me -- their average expense ratio, which, we'll unpack that a little bit later, it's only 0.11%. Meaning, you're paying a tenth of a percent to participate in owning these funds. That's so much lower than the rates that you were seeing prior to the creation of Vanguard and their low-cost funds.

Campbell: I don't know who I like to listen to more, Kristine, Warren Buffett or Bogle. Those two guys, when they get talking, you just have to tune in. They just know so much about the markets, but yet, they have very different approaches. You have Buffett who will go out there, he's the ultimate active investor, go out and buy individual stocks and hold them for the long-term. Then, you have Bogle, who says, "No, I'm going to turn this whole thing upside down on its head," and in 1975, started this company that's going to focus on pooling together other people's money and owning a basket of stocks and buying and holding that basket forever.

Harjes: And what's really interesting there is, the two men are quite fond of each other and each other's strategies. For example, Warren Buffett made a bet that a passive S&P 500 Index Fund would outperform a basket of hedge funds over a 10-year period -- so, that actively managed type of fund. This bet concluded at the end of 2017, and Buffett won, and he won by a lot. So, Warren Buffett, who you think of as the king of picking great stocks and beating the market, still will say that for many, many people, the best bet that you can make and the best way to grow your wealth in the market is through a passive index fund.

Campbell: Yeah. And he has said, when he passes away, that's what he wants his family's money to be invested in, rather than in individual stocks. So, I think that's quite a statement by such a great investor. One of the interesting things, when we were going over our notes and talking about this show, Kristine, I didn't really fully understand how Vanguard delivers those low fees to its shareholders.

Harjes: Yeah, they have a pretty incredible business model.

Campbell: Yeah! Did you know that they were a mutual company?

Harjes: I did. They're client-owned, meaning that there are no outside owners that are seeking profits. Instead, if you own the funds, you own Vanguard. So, that 0.11%, that's the company's overhead. That's the blended average across all of the funds they offer. That's the expense ratio because that's how much it takes as a percentage of assets to run Vanguard.

Campbell: Right. And with most investment companies, that money and scale that you get from having more and more money under management, leveraging that against your fixed costs, the profits would go to whoever happened to own that company. But, in Vanguard's case, it actually flows back to the shareholders and helps reduce their costs. It's a really interesting business model. Granted, we sound like we're doing an ad for Vanguard here, but I think it's important to understand why we're talking so much about Vanguard, and that's because they are the biggest manager of these index funds out there. They pioneered it. And they do a great job with it.

Harjes: Yeah, [laughs] we're definitely big fans of Vanguard and everything they've done. Personally, they were my first investment. I remember, my grandparents set me up with an account when I was pretty young, and when I was old enough to start investing my own money, when I started working part-time while I was still in school, that's where I put my money. I added to that Vanguard fund. And I still own it today. So, I've been a fan of Vanguard for a very long time. It was an absolute delight to meet Bogle last week. [laughs] But, moving on, because they really should be paying us to give all of this praise to them -- they don't need it, though, I think they get enough free advertising across and elsewhere, because everybody knows that Vanguard is pretty great.

Campbell: Yeah, 20 million investors and $5.1 trillion in assets under management, [laughs] I guess everybody is pretty much aware of them at this point.

Harjes: It's no secret. Alright, Todd, I think it's time to address an underlying tension in this show, which is the fact that we mostly talk about picking individual stocks. At The Motley Fool, we very much believe that you can beat the market by investing smartly in well-chosen stocks. So, what gives? Why all the lavish praise on fund investing?

Campbell: It's downright hard for many people to take a hands-off approach to an individual stock portfolio. And it's very hard to gather together enough money to be able to construct a portfolio that's diversified. That's why, I think, index funds and mutual funds are so popular, and that they can play a role for a lot of investors in their investment lives. You can't control Mr. Market. Mr. Market can go soaring higher or it can collapse to lows in any particular period of time. But what you can control is the expenses that you pay to have your money managed.

So, I think, when you look at the different ways that you can invest, if you're not somebody who's going to be able to keep yourself from pressing the sell button every time something bad happens to one of the stocks that you happen to love, or if you're just getting started and you don't have enough money to diversify yourself, then mutual funds can be very valuable.

Harjes: Absolutely. I think it speaks to a broader point about being humble and recognizing that it's possible that you don't have the knowledge, or you don't want to spend the time looking into a certain sector of the stock market. Or, maybe you're somebody who doesn't really want to pick out individual stocks at all. They definitely serve a very good purpose for, as you mentioned, diversification, and for alleviating some of the ways that you can go wrong when emotionally investing. We know for a fact, history shows us, that trading in and out of stocks doesn't generally go well for people. People tend to see the market go up and up and up -- or down, and then they have an even more emotional response to that. But, history will show you that if you just sit tight, that's probably the best strategy for you.

So, I do think there's absolutely a place in many investors' portfolios for funds, whether it's the majority of your portfolio, and maybe you might complement that with a few stock picks here and there, or maybe it's something where you have a diversified basket of stocks that you've picked out, but, say, you're missing exposure to international stocks because you find international markets to be kind of confusing, and you recognize that it might be a better strategy for you to just choose an international index fund to get that exposure without having to try to learn it all yourself.

Campbell: Right. And looking at it from a sector perspective, too, Kristine, you could say to yourself, maybe I like these three biotech stocks. But, biotech stocks can be incredibly volatile. They trade because of clinical trial successes and failures. There's political concerns. There's all sorts of things that can move these things up and down. And maybe you say to yourself, I'm going to own those three, but you know what else? I'm also going to go out and buy an ETF of healthcare stocks and give myself a diverse basket of that, as well.

And I know some people go out and they'll buy the S&P 500 fund, and then they'll add in and tuck around some additional stocks, maybe small-cap stocks that aren't in the S&P 500, to round out their portfolio. There's a lot of different ways that you can use these funds to help broaden out your exposure to the market and improve returns.

One of the drawbacks, obviously, of these index funds, Kristine, is that you're only getting whatever happens to be in that index. I guess that's kind of the bad side. You're not going to beat the market, because you are investing in the market if it's the S&P 500. And if it's in the S&P 500, you're not really going to get exposure to small-cap stocks. And those small-cap stocks, oftentimes, can be some of the biggest performers. It's like buying Amazon in 1997 or whenever, it wouldn't be in the S&P 500.

Harjes: Yeah, absolutely. That's a big reason why there are small-cap funds that are offered. It's not like you're prohibited from investing in these small caps, but you might have to go actively find them.

I want to circle back to a point that you made earlier about investing in a biotech ETF. I think it's worth musing a little bit on why our email account gets so many emails specifically about healthcare funds, more so than any other industry funds. I was thinking about why this could possibly be, and I'm only speculating here, but I want to say that healthcare is perceived as a riskier place to bet on individual stocks.

On this show, we talk all the time about clinical trial failure rates and tiny companies with just one drug that are binary stocks -- they're either going to soar or they're going to plummet. So, I think a lot of people have a little bit of trepidation about trying to pick out the winners when the odds are really a coin flip, sometimes. But, yet, you look at the demographic and the industry tailwinds that are supporting the industry as a whole, and I think people realize that they do want exposure to the healthcare market, they just don't necessarily want to try to play a guessing game and try to understand the science behind some of these drugs and picking them out.

Hopefully, this show has generally been helpful for the people who do want to pick out individual stocks in the healthcare sector, but I really don't blame anyone who would either like to complement their existing biotech stocks with a biotech ETF, or just avoid the individual stock-picking in the sector entirely and get that broad exposure.

Campbell: And taking that even one step further and saying to yourself, I know that, obviously, pharmaceuticals and biologics, those are going to play a big role in taking care of us as we get increasingly older, live longer, and there's a larger population. But there's also medical devices and medical equipment, there's health insurers, there are so many different pieces of healthcare to invest in, and it's very hard to do that as an individual without ending up investing $10 in each individual stock. [laughs]

Harjes: Yeah, and when you're investing small amounts in each stock, if you pay a commission on those investments, it's pretty hard to get a return that even just surpasses the commission that you're paying. So, you do want to make sure that every time you buy an individual stock, it's of a substantial enough size that the commission isn't taking out a big chunk of your potential gains before they even happen.

Campbell: That's a great point, Kristine. Turnover is a real concern. I don't think people really think about the impact it has on your returns over time. Study after study has shown that the lower that your expense ratio is, the greater the potential nest egg can become. As a matter of fact, Vanguard had done a study that showed that if you invested in something that had a 0.11% expense ratio vs. something with a 0.68 or 0.60% expense ratio, or whatever it was, that over 30 years you would add an additional $70,000 to your nest egg just from the savings.

Harjes: That's mind-blowing. Turning to strategy about how you pick out funds, when I look at different funds to try to compare them, that's the No. 1 thing that I look at -- the expense ratio. This is something that will be part of all funds. It is, as we alluded to earlier, the operating expenses. If it's actively managed, it's also probably going to include a fee to the managers.

So, when you're looking at your expense ratios, these numbers might look small because they're all maybe 1%, but they actually do really add up. Todd, I think the example that you just gave is extremely indicative that a small bit, when you compound it over time, really makes all the difference. So, make sure that you look into expense ratios very, very carefully.

One tiny detail that that you'll want to note, the net expense ratio incorporates temporary discounts sometimes. So, if you see a net expense ratio and a gross expense ratio, pay attention to the gross expense ratio. That one's more accurate because it represents the non-discounted rate, which is what you'll probably wind up paying in the future.

Other fees to take into consideration: the sales load. No-load funds came into prominence in the 1970s as the cost of trading came down. Prior to that, it was pretty expensive to buy stocks, so funds had this sales load to compensate for that. But now that it's relatively cheap to buy and sell stocks, to me, it's really not even acceptable to have a load on a fund, but that doesn't mean it doesn't exist. My advice would be, in general, try to find no-load funds.

Campbell: Just to tag onto the back end of that, there's also another school of thought there. Loaded funds aren't bad if they also give you a correspondingly lower expense ratio and you hold them for a long time. A lot of times, what you'll see is, loaded funds also have ongoing expenses that are lower than the expense ratio for the no-load fund. So, you have to build that into your thinking as you're figuring out, do I want to invest in A class shares or B class shares of this mutual fund, or whatever. Each one of those will have a different expense ratio, perhaps, and a different load associated with it. So, something to bear in mind.

Harjes: Yeah, that's a good nuance. The load can come either on the front end, meaning when you first buy it, or on the back end, when you sell it. And sometimes, a back-end load will decrease over time. So, if you plan on holding this for a very long period of time, you might find that the math works out where you can have a back-end-loaded fund with a low expense ratio for the annual maintenance, and that's fine. That ends up being favorable for you.

Campbell: Yeah. And the other thing, too, because we talked about ETFs, it's important for our listeners to know that a lot of brokerage houses now are offering commission-free trading on ETFs. If you hold them for a certain number of days, you're not going to pay a commission if you trade them. So, that's another thing to keep in mind if you're trying to figure out, do I want an ETF, or do I want to go with a mutual fund.

Harjes: Yeah, totally agreed. One aspect of funds that I think people probably overweight their attention to, but it's still important to consider, is what's actually in the fund. The strategy is definitely important. I don't think I would say that considering strategy is something people overweight or over-allocate attention to. But, there are nuances about what goes into different funds that say that they have the same strategy. For me, this is not as important as the fees and the expense ratio and the load and all that. But it's still important to consider.

Some things to look at would be, how is the fund made up? Is it, say, market cap weighted? Or is there another weighting, like being equally weighted, where every single stock in the portfolio represents the same proportion of the whole portfolio? You can also look at the ratings. Morningstar is a popular source for ratings which can tell you a lot about a lot of different qualities about the stock itself. So, you can go to Morningstar and read a lot more about how they do their ratings systems.

Campbell: Yeah. And there's other considerations, too. The industry continues to innovate. There are now target date funds that will automatically adjust your bond and your stock percentage as you get older, keeping it even more simple for you. There's leveraged funds that will lever your money three-to-one or two-to-one, which are very high-risk investments.

One of the things to consider if you're looking at actively managed funds is, consider the manager and how long that manager has been there. Because, people do retire, and you don't necessarily want to own a fund where the guy has only been there one year, and you're buying that fund because the woman who had been running it was the one who was responsible for building up that wonderful track record that's convinced you to go out and invest in it. So, consider the size of the fund, consider the manager tenure, consider the returns over a longer period, like a five or 10-year period, and of course, that all-important expense ratio.

Harjes: Yeah, absolutely. One thing that I want to mention before we wrap up is, many of the most common funds that people hold will track the entire market. These are very common in, say, your 401(k). So, many, many, many investors out there hold something that represents the entire market. The reason that I bring this up is because sometimes it's hard to remember that these funds give you exposure to some of the biggest companies that are out there. I mentioned earlier that some funds are weighted via market cap, while some are equally weighted. The most common funds are market cap-weighted, meaning, if you are a gigantic company, you're going to comprise a fairly large amount of even a broad-based index fund.

To give a more concrete example, an S&P 500 ETF contains roughly 3.8% Apple shares, 3.2% Microsoft shares, 2.8% Amazon shares, the list goes on. You can google this pretty easily. But, if you're buying Apple separately from that, it's kind of important to remember that you already have 3.8% of however much money you've allocated to the S&P 500 in Apple. This is something that I forget about all the time. I'm an Apple shareholder, so I constantly have this battle with myself of, do I really want more than that percentage of Apple? And maybe you do. But, maybe you don't. So, important to keep that in mind when you're looking at your overall portfolio allocation.

Campbell: That carries over into healthcare, too. If you buy a healthcare ETF and it's market cap-weighted, you're probably going to end up with a lot of Johnson & Johnson. As a matter of fact, Vanguard's healthcare ETF, I think the symbol there is VHT, I think there's 362 stocks that that ETF owns, but the top 10 stocks represent 44% of the portfolio.

Harjes: Yeah. I think that's one of the biggest arguments against investing in funds -- you don't really get a say in that. Maybe when you look at that list of the top 10 healthcare giants that are in some of these healthcare funds, maybe you think that seven out of 10 are not good investments. To me, at least, that's a very compelling reason not to invest in funds. Of course, I think there are very good reasons to invest in funds, too. But, as with any investment decision, there are going to be pros and cons.

I guess, in wrapping up, although at The Motley Fool we strongly believe that you can beat the market by choosing individual stocks, we also wanted to recognize that there's a time and a place for investing in funds as a part of a smart, market-beating strategy. To all of our listeners who emailed in, I hope this has been helpful. Thank you so much for your questions! Keep them coming.

As always, people on the program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Todd Campbell, I'm Kristine Harjes. Thanks for listening and Fool on!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Kristine Harjes owns shares of Apple and Johnson & Johnson. Todd Campbell owns shares of Amazon, Apple, and Microsoft. The Motley Fool owns shares of and recommends Amazon, Apple, and Johnson & Johnson. The Motley Fool has the following options: long January 2020 $150 calls on Apple, short January 2020 $155 calls on Apple, and short May 2018 $140 calls on Johnson & Johnson. The Motley Fool has a disclosure policy.