What's the difference between an index fund, mutual fund, and ETF? A mutual fund is a professionally-managed investment fund that uses money from many investors to buy stocks, bonds, or other securities and assets. Think of it as a bundle of stocks or bonds that has been put together by a professional fund manager instead of an investor picking individual stocks to build their own portfolio. Mutual funds can be actively managed by a professional fund manager, who is paid for their knowledge and expertise to analyze, buy, and sell individual stocks, bonds, or other securities and assets that they believe will give their investors the best return. In turn, for this service, the fund can charge the investors a fee, which, on average, is about 0.62%.

Mutual funds can also be passively managed, whereby all an investment company has to do is set a computer to track or mirror the performance of a specific index, like the S&P 500, and buy all the companies or shares that make up that particular index. The aim of an index fund is to mirror or replicate the returns of their benchmark indexes. Because no analysts are needed to research the companies that are added to the fund, the fees on an index fund are much lower than an actively managed fund. On average, the fees for index funds are 0.12%.

ETFs, which stands for exchange traded funds, are similar to mutual funds in that they are a vehicle to invest in a variety of stocks and/or bonds that an investment company has put together for you, but they are structured a little differently. In fact, both an index fund and ETF can track the exact same index, but with an index fund or mutual fund, you are buying and selling shares directly with the fund company. Mutual funds are also traded just once a day, based on that day’s closing price. This means that when you, an investor, place a purchase order for mutual fund shares during the day, you won’t know what the purchase price is until the next day. Some mutual funds may have a minimum amount that you need to invest in in order to buy those funds. One advantage of mutual funds is that you can buy fractional shares, which makes investing easy since you could set up automatic contributions to buy whatever fixed dollar amount you want invested each time. ETFs, on the other hand, are like a mutual fund that has been repackaged to be listed on an exchange, hence the name exchange-traded fund. Unlike mutual funds, however, the investment company that created the ETF doesn't sell individual shares directly to retail investors. The ETFs are sold to financial institutions, and the broker in turn sells those shares on the national stock exchanges to retail investors. ETF shares can be bought and sold from your stock brokerage throughout the day just like a stock, so you have greater control over the price that you pay since they are sold at market prices. With an ETF, some brokerages, like Vanguard, only allow you to buy whole shares.

Why are index funds and index ETFs recommended by Warren Buffet, Burton Malkiel, and Harry Markowitz, and why are they so popular among investors today? There are four main reasons:

#1 Instant diversification. For individual investors, index-tracking funds and ETFs provide substantial diversification without the research, time, effort, and expense required to construct your own custom portfolio of stocks and/or bonds. If you purchased index funds or index ETFs, for instance, one that tracks the S&P 500, you would be instantly invested in 500 different companies. Diversification greatly reduces the risk of any one company going out of business and the stock price dropping to zero. When you invest in, say, the total stock market, the chances of the entire stock market crashing to $0 is very unlikely, so compared to buying individual stocks, index funds are much lower in risk.

#2 Lower fees. Index funds have very low fees. The expense ratios for actively managed mutual funds currently average about 0.62% percent. By contrast, index-tracking mutual funds and ETFs typically feature fees that are a fraction of that. The expense ratio for VTI, Vanguard’s total U.S. stock market ETF, is only 0.03% percent. Over time, low fees can make a huge difference in long-term gain because of the effect on compound interest on the fees. Most investors are unaware of all the types of fees that they're paying.

#3 Performance. Index funds are often recommended because of their performance. They are simple, but effective, and they produce higher returns than 80% of actively managed funds over a twenty year period. Investors are essentially paying for professionals to manage their portfolio who aren’t producing higher returns.

#4 They make investing simple. You could hold just three funds in your portfolio and be completely diversified.

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