Both mutual funds and ETFs are very popular stock investment vehicles. Both help you achieve diversification, since both invest in a wide variety of companies. For example, if you invest in a health care ETF or mutual fund, both will invest in a wide variety of health care companies. The difference though is how they invest in the companies.

An ETF blindly follows an index. For example, in the health care example, the ETF will blindly invest in the same companies that make up a certain health care index. This allows the ETF to charge a smaller fee than the mutual fund because the ETF does not have to “think.” In contrast, the mutual fund has active management. So in the above example, the mutual fund would hand select which health care companies it wishes to invest in. This “thinking” generally equates to about 1% more in fees per year, so the mutual fund needs to outperform its respective ETF by 1% a year in order to justify the fees.

Many are critical of mutual funds because they do not believe they can outperform the ETFs, so people are needlessly paying fees. If you think you found a mutual fund whose manager is very good though, that manager should be able to outperform by the 1% fee.

If you think mutual funds charge a lot, then compare them to hedge funds. These investment vehicles charge 2% of assets plus 20% of whatever you make per year. This is a lot compared to a 1.2% of assets of a mutual fund and perhaps .2% of assets for an ETF. Due to the recent stock market collapse, people have been pulling money out of hedge funds like crazy. George Soros believes the hedge fund industry may contract by 2/3.