Index funds, most popularly used in their exchange-traded fund (ETF) format, compare well to mutual funds. They both feature portfolios of stocks, bonds, or other asset classes pooled together to diversify their level of risk, and they’re based on the fund’s core strategy (such as tracking the S&P 500 index or making the “American Funds Growth Fund of America”).
Index funds are no more or less risky than mutual funds. There’s no significant evidence that index fund ETFs are riskier than mutual funds, whether they’re passively or actively managed. Each asset’s risk profile is dependent upon inherent financial risks and the underlying securities they track.
Index funds and mutual funds both invest in groups of securities in order to capture a larger portion of the market than investing in a single stock ever could.To understand the risk profiles broadly associated, an investor needs to understand how each of them works. Read on to learn more about index funds and mutual funds, how they work and how their structures and risk profiles may differ.
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Index Fund ETF Risks
Whether ETFs are riskier than mutual funds is clearly laid out and can be well summarized in a quote from Mackenzie Investments, a Canadian provider of both mutual funds and ETFs:
“There’s no notable research that demonstrates that ETFs are riskier than mutual funds.”
They go on to explain that “the risk or volatility associated with any fund structure, whether ETF or mutual fund, is influenced by various factors.” Ultimately, any fund’s risk is dependent upon its portfolio of underlying securities.
ETFs are securities that trade on the open market representing baskets of individual stocks, bonds, or other securities. They’re provided by ETF providers that sell their securities under a unique ticker symbol, offering investors coverage over a sector (technology, healthcare, etc.), index (S&P 500, Russell 2000, etc.), or type of asset class (bonds, gold, cryptocurrency, etc.).
ETFs can be passively managed, such as index funds. And ETFs can also be actively managed, such as those pursuing a distinct strategy cooked up by educated asset managers. The fees for investing in actively managed funds are typically higher for their manager’s efforts.
Index fund ETFs are built by adhering to the structure of the specific index they are designed to match. Their holdings are generally weighted by market capitalization (meaning the total value of the stock’s shares in the overall market); [$ price of a single share x # of outstanding shares = market cap].
The purpose of an index fund is to exactly match the overall market performance of the index they track. The ETF “SPY” tries to match the day-to-day and year-to-year price movements of the S&P 500 index, the most extensive equity index in the world. The ETFs “QQQ” does the same for the NASDAQ index of technology stocks, and “IWM” tracks the Russell 2000 index of notable small-cap stocks.
When considering the risk of any index fund, whether you’re investing in an ETF or mutual fund, you should primarily be concerned with the risk of the index’s portfolio itself. Whether you use an ETF or mutual fund to gain market exposure to your favored index or strategy is up to your own preferences.
So, as investment assets, how do mutual funds differ in their structure?
How Mutual Funds Work? And, How Do They Differ From ETFs?
While mutual funds can be passively managed or actively managed, much like ETFs, they started first as actively managed investment vehicles led by sophisticated investment professionals trying to outperform the market as opposed to matching it.
Nerd Wallet writes up a concise and informative comparison of index funds and mutual funds, in which they explain that active mutual funds try to beat the market, feature higher fees, and have overall price-performance that is much less predictable than passive index funds. On average, they also underperform passive index strategies in the long run.
Mutual funds, as defined by Investopedia, are “a type of financial vehicle made up of a pool of funds collected from a number of investors to invest in securities like bonds, stocks, money market instruments, and other assets.” They’re operated by professional money managers, who assign the fund’s assets to produce income for the fund’s investors and capital gains. A mutual fund is structured to match the investment objectives stated in its prospectus.
Mutual funds are an older style of investment than ETFs (with the former being launched in 1924), and another of their primary differences is how they are traded. ETFs trade much more readily and efficiently on the open market exchanges, similar to stocks themselves.
Mutual funds, on the other hand, feature different classes of shares and typically must be purchased through their provider firm (such as Fidelity or Vanguard), often with a required minimum investment.
In all, mutual funds share many of the same features provided to retail investors, such as portfolio diversification and investment management – active or passive in nature – as ETFs do. The primary differences come in their structure and not necessarily their risk profiles.
Let’s discuss the risks of index funds and mutual funds next.
Comparison of Risk Profiles: Index Funds vs. Mutual Funds
The risks associated with index funds and mutual funds both deal with the inherent financial risks of any security-based investment trading on the open market. In short, the primary risk for stock market investing is that you can’t tell the future! You can’t ever know if your investment, when purchased at present, will go up or down in value in the future.
This risk makes up the customary refrain in prospectuses for investment funds of all kinds, and, as noted by the U.S. Securities and Exchange Commission, “past performance does not indicate future results.“
The most common financial risks are credit risk (i.e. risk that your borrowers do not repay), liquidity risk (i.e. risk of bankruptcy), and operational risk (i.e. risk that your core business sales do not grow). Other financial risks include currency, inflation, interest rate, country, and overall market risk.
All these risks inherently apply to all securities, including securities that track other securities – such as both mutual funds and ETFs. Whether they’re tracking an index or are actively managed with cherry-picked stocks that asset managers specialize in researching and forecasting, these financial risks will apply to both classes of assets.
No matter how you invest in the stock market, you’ll be susceptible to these financial risks. It’s part and parcel of playing the game of investing.
Thus, the overall risk profiles of index funds and mutual funds are actually quite similar. Their differences, as discussed, come with their structures and fees, how they trade, and what they’re typically pursued by investors for (index strategy for ETFs and active management for mutual funds).
Financial industry titan, Vanguard, features a very useful article (link in article sources down below) outlining comparable ETF vs. mutual fund explanations based on common investor preferences, such as low investment minimums vs. hands-on control over the investments and others.
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Conclusion
Index funds are no riskier than mutual funds. The risk profile for either type of asset – of which there are many, many different kinds – comes with the inherent financial risks they share and depends on the specific portfolio of underlying assets that they track.
When considering index funds versus mutual funds, an investor should educate themselves on how each asset class works. From there, you should consider your financial goals and make your choice based on what you want out of your investments, both in terms of period-to-period management and overall outcome.
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