Passive Investing 101: ETFs + Index Funds + Mutual Funds Explained

Passive investing includes assets such as ETFs, index funds and mutual funds. Here is an overview on these different investment vehicles for beginners.

Okay so now we’re on to one of the parts i’ve been really looking forward to we’re going to talk about mutual funds and these are dogs when it comes to investing so active money management is expensive anytime you guys hear the words active management when it comes to money i want you to think of expensive in your head most retail investors cannot afford professional

Management of their money so for a while this was kind of a problem but then the mutual funds came around and what this does is this allows small investors to collectively pull their money and have it managed on their behalf so before the etf or the exchange traded fund was born in the 1990s this was the only option aside from investing in individual stocks or

Paying for professional management now i’m guessing as somebody who was watching this course you’re somebody who is interested in managing your own money and possibly picking your own stocks for long-term investments or whatever strategy you do decide on but for those of us who are not interested in an active investing approach and we want something more passive

For a while the only option you had was these actively managed mutual funds but now the etfs have really changed the whole investing scene in a mutual fund securities like stocks and bonds are constantly being bought and sold resulting in a flurry of transaction costs and commission costs and a tax drag so later on in this course we’re going to talk about investing

Taxes and you have long-term capital gains tax and short-term capital gains tax and often times when these mutual funds are reallocating a lot of those capital gains fall under the higher rate or that short term capital gains tax another thing to realize about mutual funds is that a certain amount of the fund is always held in cash for redemptions and this is known

As the cash drag of a mutual fund they always know that there’s going to be a certain percentage of people that are going to redeem on any given day or any given period of time so in order to have liquidity and the ability to pay those people off they need to have a certain portion of the portfolio sitting there in cash and sometimes they will leave some money

In cash to wait for an investing opportunity now as somebody who is investing you may not be interested in that because that is known as a cash drag and that is money that could be working for you but it’s not because they’re leaving it they’re in cash so the expenses for managing the fund as well as researching and analyzing stocks are passed along through the

Expense ratio and most people should hold exchange traded funds instead of mutual funds now i was going to go into a whole section on this and talk all about this but i really didn’t feel i could do this justice just because so many people before me have addressed this topic if you guys really want to learn about the true cost of active money management i want to

Point you in the direction of money master the game by tony robbins or if you want a more condensed version of that book he recently released the book called unshakable and those really pointed out to you what the true cost of active money management is but i am going to go over a few statistics for you but just understand that the mutual funds came around as a

Solution to the fact that most small investors could not afford active money management they can’t pay a financial advisor to invest on their behalf but when they collectively pooled their money they could afford to have professional money management however now that the etfs have hit the scene and people can have broad market exposure at a very low expense ratio

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Most mutual funds are not beating what these markets are paying and this is why most investors if not all investors should be holding exchange traded funds i want to throw this statistic at you guys so in a 10-year period ending in 2015 82 percent of actively managed large-cap mutual funds failed to beat the return of the s p 500 so mutual fund investors pay a

Premium for the active management of the fund however if 82 are not beating the market what exactly are you paying for what value are they adding by actively managing that fund if you have a mutual fund make sure the fund is consistently beating the return of the market i want you guys to realize that in that 10-year period you could have invested in a vanguard 500

Fund that tracked the s p 500 for a very low expense ratio i’m talking a fraction of what these mutual funds are charging you through an expense ratio and you would be paying less expenses also beating the return of that mutual fund so if you guys currently have a mutual fund what i want you to do as i want you to benchmark it to the s p 500 i want you to take

The performance of that fund compared to the s p 500 and remember to subtract the expense ratio from that return so if you saw a nine percent return from your mutual fund but they’re charging a two percent expense ratio understand that’s really a seven percent return so if after expenses your mutual fund is consistently beating the market return then you have a

Good mutual fund but most of them are not in fact 82 percent are not beating the market before you even factor in the fact that their expense ratio comes off of the return the number is very low guys very few mutual funds are beating the market return and that is why most passive investors should hold index funds or exchange traded funds you should not be investing

In mutual funds unless your mutual fund is consistently beating the s p 500 and the overall return of the market other than that you should just hold the broad market through an etf okay so now we’re going to talk about my favorite investment vehicle the exchange traded fund so mutual funds and etfs are very similar so we’re kind of going to be going back and

Forth in this section here now an etf or an index fund is a fund that tracks a specific underlying market so later on we’re going to talk about stock market indexes i’m sure you’re already familiar with the s p 500 the dow jones industrial average and you could find an etf that tracks both of those so the truth is most investors are not able to consistently beat

The market and if we use the statistic from the last slide we saw that 82 percent of professional money managers are not able to do this so the big question people ask is this if these professionals are not able to beat the market how would you be able to beat the market but you do have to understand that when you’re managing a larger amount of money you can’t

Necessarily change things around as easily and you do have things like cash drag that are going to slow down the fund as a whole so i think if you are an active manager of your own money and you really do know what you’re doing and you uh really do study and focus on long-term investing and really understanding the value of what you’re investing in you could be

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Somebody who beats the market i mean i’ve been able to beat the market on a pretty consistent basis here so it’s not impossible but many people are not even interested in trying that but they still want to invest and that is when you should be investing in these exchange traded funds rather than picking stocks and trying to beat the market many decide to own a

Piece of the broad market which is a great strategy and rather than paying for active management with lackluster performance and by lackluster i mean as you can see eighty two percent failed to do their job most should hold index funds over mutual funds in fact i believe everyone unless you’re in a mutual fund that consistently beats the s p 500 at a rate that

Exceeds the expense ratio so even if they’re getting a nine percent return if they have a three percent uh expense ratio they’re probably not beating the average return or the annualized return of the s p 500 so rather than paying for active money management when these active money managers are not able to provide the results you are expecting just own the whole

Market rather than trying to beat the market yourself many people want to just hold a broad market index so an index is a tool used to measure the value of a portion of the total market and we’re going to talk about indexes later on index funds are designed to replicate the performance of the underlying index so if there was an index fund tracking the s p 500 the

Index fund would be allocated such that it replicated the performance of the s p 500 now index funds give you broad market exposure with a lower expense ratio due to the passive management so there’s no active analysis there’s no active research that goes into an index fund because they’re just replicating the performance of an underlying index and as a result the

Expense ratio is significantly cheaper and even better i recommend vanguard index funds because they are some of the lowest fee index funds on the market so if you’re going to go with index funds which i recommend you do or these exchange traded funds your best bet is to go through vanguard and they offer index funds you can invest in like a mutual fund through

The vanguard account or exchange traded funds that trade on the secondary market like a stock so the other benefit to exchange traded funds is that the only time the investments change is when the underlying index changes so as a result index funds have a lower turnover resulting in less commission costs and tax drag because most of this is going to fall under the

Long-term capital gains tax so all of these things combined make index funds a great passive income strategy and they’re very simple there’s not a lot to them it’s very passive you go ahead and buy index funds and maybe you’re going to follow the strategy of dollar cost averaging which we’re going to talk about later where you’re slowly adding to this over time

And maybe you have an etf fund tracking the s p 500 and an etf fund of high quality long-term government bonds or whatever your bond allocation is and over time you’re just going to continue to add to these things the biggest difference between a mutual fund and an exchange traded fund is how they are purchased so mutual funds are purchased through the issuing

Investment company so maybe it’s franklin templeton maybe it is fidelity but you’re gonna go through that website and you’re gonna open an account with them and oftentimes they have a minimum balance to actually open an investing account so etfs are traded on the secondary market like a stock which is beneficial to investors because if you already have a trading

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Account you don’t have to set up a separate account in order to invest in an index fund you can do it through exchange traded funds this is index funds traded like a stock so most mutual funds like we said have a minimum balance to open an account while an etf can be purchased as individual shares so you can get involved with an etf for the price of a single share

Whereas with a mutual fund or an index fund you would have to pay the minimum balance and i do know if you go on the vanguard website they call these a mutual index fund um so they do call them a mutual fund but it’s a very low expense mutual fund now etfs are significantly cheaper in terms of management fees and expenses you guys can look at the average expense

Ratio of this or compare some other vanguard funds to the other funds out there and this is represented in the expense ratio of the fund okay so now we’re going to have a little bit of fun here i’m going to compare the performance as well as the expense ratio of one of the most expensive mutual funds i have ever found compared to a vanguard index fund so here we have

The oppenheimer steel path mlp which is a master limited partnership select 40. so this is basically a fund that invests in oil and gas limited partnerships and as we can see this mutual fund has an astronomical expense ratio of 5.66 this is one of the highest expense ratios i have ever come across so i want you guys to pay attention to this chart okay and tell

Me if you see any similarities when we look at the next chart because i’m guessing as you can tell they look very similar very similar performance from these two funds here so here we have the vanguard energy index fund admiral shares so this is a pool of stocks of companies involved in energy products such as oil and gas and look at that expense ratio guys the

Expense ratio for this vanguard index fund is 0.1 percent compared to an expense ratio of 5.66 percent from the actively managed mutual fund and as you can see the performance over the last five years has been very very similar so this is just an example of how expensive mutual funds can really be and this is why you can usually find an index fund that’s going to

Give you the exposure that you’re looking for both etfs and mutual funds are pools of money allocated into a portfolio of investments both etfs and mutual funds offer diversification for broad market exposure the investor who buys either a mutual fund or an etf has no input on what investments are included within the fund so this again comes down to whether you’re

Looking for a passive investing approach or an active investing approach if you’re looking for a passive approach you would be somebody who invests in funds because you do not want to be worrying about asset allocation yourself but if you want a more active approach you might be somebody who invests in individual stocks themselves because you want to have a say in

What you’re investing in now both etfs and mutual funds are passive investing approaches and there’s no reason to say you couldn’t have a mix of a passive and active investing approach where maybe you have half of your money in etfs and you have half of your money in individual stocks this might not be a bad strategy either if you want to have a mix of both worlds there

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Passive Investing 101: ETFs + Index Funds + Mutual Funds Explained By Ryan Scribner

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