ETFs, index funds, active funds – making the right choice

The world of investing can be confusing. How do we make the right choices when it comes to allocating our hard-earned capital?

Let’s explore some options that might be appropriate and effective.

Investors looking for diversification often turn to the world of funds, and for good reason. Actively managed mutual funds, index mutual funds, and exchange-traded funds can provide broad, diversified exposure to an asset class, region or specific market niche without having to buy scores of individual securities.

The challenge lies in narrowing down your options. So, let’s look at some of the benefits and drawbacks of each, and how they may fit your needs.

Mutual funds

Generally speaking, there are two types of mutual funds: actively managed funds and index mutual funds.

Actively managed funds: The investments in these funds are selected and managed by a portfolio manager or team based on their strategy and outlook, generally with the goal of outperforming the market, such as by playing defense during a turbulent market.

Active funds may also be an attractive option for investors looking to access harder-to-reach or less-transparent market areas, such as emerging-market bonds, where a fund manager’s experience and expertise can be invaluable. Of course, such expertise comes at a cost: actively managed funds tend to charge higher fees than ETFs and index funds that attempt to mirror, rather than beat, the market. However, financial expertise doesn’t guarantee that an active fund will outperform the market – and in some cases, it may even underperform it.

Index mutual funds: These funds generally seek to replicate the performance of a particular index – also known as passive management – which typically results in lower expense ratios than actively managed funds. They can be an attractive option for investors looking for a low-cost way to capitalize on the long-term direction of the market.

That said, passive fund managers have little ability to change course in the midst of a market downturn or rally, so investors looking for more defensive and/or aggressive management styles may find active funds more to their liking. They want to know someone has the ability to zig when the market zags.

Exchange-traded funds

Like index mutual funds, ETFs generally are passively managed and offer similar investment strategies and charge similar fees to traditional index mutual funds. However, ETFs trade on national market exchanges just like stocks and, as such, may incur trading commissions, though many brokerages now offer commission-free ETF trading.

The ability to trade ETFs intraday means investors can employ the same order types allowed with traditional equities, such as stop orders and limit orders – something that’s unavailable with mutual funds because of the way they’re bought and sold.

All investment vehicles have their pros and cons, and I encourage you to educate yourself about various funds that might be appropriate for your portfolio. At Schwab, we offer a no-obligation, no-cost investment review that could help you understand how you are invested and what you are paying in fees and fund expenses; I believe this is time well spent.