What The F@%K are Index Funds, ETFs and Mutual Funds?
Enough of the financial jargon!
It’s finally time to dive deeper into the investing portfolio and really understand what’s going on. In my ‘Simple Steps to Start Investing’ guide I explain that the best way to get started as a student who wants in on the game of investing is through passive investing: index funds through a robo advisor.
But I also say that it’s important to understand what you’re doing before making any investment decisions. So here I am to explain to you what exactly index funds are all about and why, as a student, you’re better of investing in index funds rather than ETFs or mutual funds.
If you’re completely new to investing I recommend reading my WTF is investing post beforehand, or this may just seem like a ton of jargon to you.
Here’s what we’ll be talking about:
The difference between the three
How to get started in college
Mutual funds are the oldest type of fund investing of the three. The grandad of investment funds, the old but gold, the most well known. But it doesn’t necessarily mean the best. Here’s why:
Put simply, mutual funds are like a basket of bonds, stocks and other assets specifically chosen by a human manager. The manager takes your money and then puts it in this basket that allocates a percentage of it to certain stocks and bonds. Say you invest £100 into mutual fund X that allocates 20% bonds and 80% stocks. Then you’ll have £20 in bonds and £80 in stocks (magic!).
This manager will be choosing which companies to invest in and how much to put in. Of your £80 in stocks, £5 might go to Apple, £20 to Intel and £55 to Coca-Cola (rudimentary example but you get the gist). These managers say they’re experts and tell you they know which companies will do well and that those £55 you put in Coca-Cola will turn into £60.
Since they’re actively managed, their management fees are pretty high; the fund manager may say you get a return of 6%, but after all fees and trade costs, you’ll really only be getting 4%. So in fact you won’t be getting £60, more like £57. You’ve also got the added risk that the human gets it wrong (remember, we’re human), and you get £50 instead, losing £5. And yes! You’ll still be paying them a fee!
Index funds are the easy and simple way to invest.
Imagine a mutual fund for a second. Imagine the manager of this mutual fund decides to take a market (FTSE 100, S&P 500, etc) and invest in every single company in that market. At that point in time, Coca-Cola accounts for 0.3% of the FTSE 100, EasyJet for 1.5% and Burberry for 0.12%. So the manager creates a fund and allocates 0.3% of it into Coca-Cola, 1.5% into EasyJet and 0.12% into Burberry. That’s just for three companies. Now imagine she decides to do it for the entire FTSE 100 and copies every percentage of each company to her fund. Now imagine this identical mutual fund, but without the active manager in place. That’s an index fund.
It’s basically a copy of the big, well-known markets. And every time that EasyJet’s percentage changes in the market, so does the index fund. If the FTSE 100 produces a return of 7% one year, so will the index fund. And since there is no stock-picking involved, there’s much less work to maintain the index fund – which means very low fees.
This is why we call index funds passive investing. Oh and the best part? Index funds have proven time and time again that in the long run, they will do better than mutual funds. It’s crazy but it’s true.
Index funds are great for putting in your money and forgetting about it – great for people who don’t have interest/time to investigate stocks (basically us students).
stocks? nah I’m into the index funds
Similar to index funds. However, instead of tracking an entire market, an ETF tracks smaller or different markets. If the index fund tracks the 100 largest UK companies (FTSE 100) an ETF might track only bank stocks, or only energy companies, or only stocks in Singapore. They’re like an index fund but only tracking specific sectors. They’re also traded like stocks – you can sell and buy an ETF.
It’s more risky than index funds since these smaller markets are more volatile and unpredictable, however you also have the ability to sell short and buy on margin, so they give you more flexibility.
In the past few years index funds have gotten more and more popular, simply because people are now realising that mutual fund managers are ripping them off and don’t even perform that well. They are low cost, they are pretty secure and they will produce the same return as the market. Over time, they are great to accumulate wealth and aren’t risky. Passive investing has come into force and it’s only going to get better, friends.
So index funds are great for people who aren’t interested in stock-picking or trying their luck by investing in the next Apple or Snapchat. They’re great for people who want to get in on the stock market and accumulate wealth but don’t want to get their hands too dirty: you hear that college students?
In college we have other things to worry about than BP’s shares going down 5% and calculating when to sell next. We don’t have time to get to know the intricacies of the stock market and which mutual fund has hidden fees or is ripping off the most. What we want (or should want) is a safe place to put our money for the future, a place which will also help us accumulate wealth.
How to get started in college
Check out the ‘How to start investing in college guide’ for a better understanding of the entire process. Here I’m going to talk about specifically investing in index funds, which can work whether you’re investing with a robo advisor or a normal platform.
You need the right tools for this. It all starts with finding the right index fund – the one that works best for you.
Here are some examples of cheap index funds (taken from This is Money UK). The percentages are the fees:
So as you can see there’s quite a range of index funds. Vanguard also offer a cool LifeStrategy portfolio which is like an international range of stocks and bonds. Find out more at Vanguard LifeStrategy.
Pick one of the companies listed above (or any others that interest you) and sign up. You’re not putting any money yet, just researching. Look at the different funds they have, read the Terms and Conditions and make sure you can see all the costs. Sign up to several of the platforms and compare. What kind of funds do they have? Which one is easiest to navigate? Which fund has performed best over the past few years?
Check out my Resources page for websites, blogs and more advice on comparing index funds.
Once you’re 100% sure on the platform you’ve chosen (and I really mean 100%), it’s time to get started. The best tool to invest is through an ISA; tax free and you can pile on a maximum of £20,000 every year. If you already have a Cash ISA somewhere else that’s fine, the important part is that you contribute a total of £20,000 or less once both ISAs are added together.
Get your account verified, and add some money into the account. From there you ‘buy’ your index fund through the ISA and wait for the transfer to take place. Following the 15% rule (check out Graduate Financially Mint course for more details) you can set up a direct debit to the platform so that every month you add some money into your ISA. And ta-da! That’s you investing in index funds!
I invested in Vanguard LifeStrategy, Emerging markets and still have some cash to invest. This is what my portfolio looks like as of 23/03/18:
So as you can see, passive investing is really not that complicated. You just need to understand what index funds are all about and then do the research to invest in low cost funds. As a college student, index funds are great to get started with investing and accumulating wealth in a low-risk and interesting way. Oh and the satisfaction to see your pool of money grow… sometimes it does beat using that money for a new phone.
Read more like this over at Financially Mint
