Index Funds vs. ETFs vs. Target-Date Funds: Build a Diversified Investment Portfolio

Whether you’re a first-time investor or a pro, diversifying your investment portfolio on your own can be complicated and expensive.

The cost of buying individual stocks and other securities can add up quickly. What’s more, handling the taxes involved can be a hassle.

The good news is that there are easier and cheaper ways to diversify your portfolio.

Mutual funds were invented to simplify the diversification process.

But what type of mutual fund should you get? To help you, we’ll cover three types diversified options: index funds, ETFs, and target-date funds.

Each of these fund options allows you to invest in a wide range of securities. And you can do so needing to pick individual stocks, bonds, and other assets.

That said, each fund type functions differently.

Before you invest, it’s important to understand how they work and whether or not they’re the best option for you.

Index Funds

Index funds essentially mimic popular indexes used to track financial markets.

For example, the S&P 500 is a popular stock market index. It’s based on the market capitalizations of 500 large U.S. companies.

Index funds that imitate the S&P 500 simply invest in all of the stocks that the index tracks.

Other popular indexes include:

• Russell 1000: Tracks the stocks of 1,000 of the largest companies in the U.S.
• Wilshire 5000: Tracks more than 6,700 publicly-traded U.S. companies.
• NASDAQ Composite: Tracks 3,000 equities listed on the NASDAQ stock exchange. It includes stocks, real estate investment trusts, limited partnership interests and more.
• NYSE Composite: Tracks more than 1,900 stocks listed on the New York Stock Exchange. Includes some from foreign companies.

You can choose from index funds that track these or any other number of available indexes.

The right index fund for you depends on the type of investments and level of diversification you want.

Index funds are relatively inexpensive compared with actively-managed funds. That’s because fund managers aren’t constantly buying and selling securities within the fund.

The only changes they make are based on maintaining the correct weightings to match the index’s performance.

As a result, index fund expense ratios are remarkably low.

This is the fee that the fund charges shareholders on an annual basis. According to the Investment Company Institute, the average expense ratio is a minuscule 0.09%.

On the flip side, financial markets aren’t immune to downturns. If one happens, there’s nothing to keep index funds from crashing along with the market they track.

Best for:

• Investors who prioritize a passive, buy-and-hold investing strategy.
• Beginners who need an inexpensive and uncomplicated investment option.
• Investors who want to pick funds based on their risk tolerance and time horizon.

Exchange-Traded Funds (ETFs)

Like index funds, ETFs are mutual funds that track a specific set of securities. You can find ETFs for stocks, bonds, commodities, and more. The difference is that ETFs can be traded on an exchange, such as the NYSE or NASDAQ, like a stock.

Also, unlike traditional mutual funds, ETF prices change throughout the day.

Traditional mutual fund prices update daily as the market closes. You can also short-sell them, buy them on margin and purchase as many shares as you’d like.

In other words, ETFs provide the same kind of diversification of an index fund. At the same time, they add some extra flexibility for sophisticated investors.

ETFs are inexpensive relative to many other fund options. The average expenses ratio for index equity ETFs at 0.23%.

Best for:

• Investors who want to diversify without losing the flexibility of trading individual securities.
• Beginners who want an inexpensive investment option but want more control.
• Investors who want to pick funds based on their risk tolerance and time horizon.

Target-Date Funds

These funds can be a good choice for people who want to invest but don’t want to deal with the planning involved with it.

With a target-date fund, you choose a fund that aligns with your time horizon. If you’re planning to retire in 2040, for instance, you can choose a 2040 fund with one of many brokers.

A target-date fund is essentially a mutual fund made up of several mutual funds. It bases its investment strategy on how much time you have until your target date.

If you’re still many years or decades away, it might be more aggressive.

The best part:

Over time, the fund will gradually switch to more conservative allocations so that you take on less risk as you approach retirement.

Throughout the process, the fund will also rebalance its assets regularly to ensure they don’t shift off course in a dynamic market.

One major drawback with some target-date funds is that they can charge high fees.

In some instances, the target-date fund itself can charge an expense ratio.

Plus, the mutual funds within the target-date fund can charge their own expense ratios.

The average expense ratio, according to the Investment Company Institute, is 0.66%.

That’s not always the case, though.

For example, Vanguard target-date retirement funds charge an average expense ratio of just 0.13%.

Also, since the fund’s investment strategy is based on your time horizon alone, it doesn’t consider your risk tolerance.

Plus, you don’t have any say in how you invest your money.

Best for:

• Investors with a clear idea of when they’ll need the funds.
• Beginners who don’t know how to pick funds.
• Investors who want someone else to manage their funds from start to finish.

How to Build a Portfolio With These Investment Options

When building your investment portfolio, it’s important to consider several different factors. The most important factors include:

• Risk tolerance
• Time horizon
• Tax efficiency

Risk tolerance

Your risk tolerance shows how willing you are to take on risk in return for the potential of higher returns.

Since that can be hard to measure, use a risk tolerance assessment to get a better idea of where you stand.

Risk tolerance questionnaires will ask you several questions.

For example, how your friends might describe you as a risk taker and how comfortable you are with stocks.

They’ll also put you in various hypothetical situations with potential risks and ask how you would respond.

There are no right or wrong answers to these questions; they’re designed to help you create a portfolio that suits your risk tolerance.

If you build a portfolio that doesn’t match your risk tolerance, it can be harder to avoid making emotional decisions with your investments.

If you have a high risk tolerance, you may want to build a portfolio based largely on stocks. You may even consider including small-cap and foreign stocks, which provide a high risk-return ratio.

If your risk tolerance is conservative or moderate, though, you may want to mix in some more bond funds to limit your risk-taking.

Time horizon

The longer you have until you need the money from your investments, the more risks you can afford to take.

History shows that downturns in the financial markets don’t last. So, if you’re just starting out in your career and plan to retire in 40 years, you can afford to take on more risk for the potential of a better return.

If your risk tolerance is right, consider high-risk funds when you’re this far out from retirement.

On the flip side, if you need the cash in the next five to 10 years, you might want to consider going with more conservative funds.

That way, your wealth doesn’t take as much of a hit if the market experiences a correction or a major recession.

Tax-efficiency

In addition to matching your portfolio to your risk tolerance and time horizon, it’s also important to try to limit your tax liability.

You can do this in two ways:

• investing in tax-advantaged funds
• investing through tax-sheltered accounts

Tax-advantaged funds include investments in securities like municipal bonds and treasury bonds. While these don’t offer high returns, they can protect you from federal or state taxes, depending on the bond type.

You’ll also want to look at different types of accounts in which to invest in funds.

For example, 401(k) plans and individual retirement accounts (IRA) are ideal for retirement investments. They’re designed to offer special tax advantages.

With a traditional 401(k) or IRA, your contributions are tax-deductible in the current year. Plus, your investments grow tax-deferred until you withdraw in retirement.

Roth 401(k) and IRA accounts allow you to make contributions with after-tax dollars. Then over time, your investments grow tax-free.

Bottom Line

Index funds, ETFs, and target-date funds can all be good choices for investors. It’s just a matter of which ones fit your investing style best.

As you build your portfolio, consider your personal preferences and your investment goals.

Also, consider working with a financial advisor. A good advisor can help you walk through each option and even help you pick the right funds.

Most importantly, don’t be afraid to make changes down the road if you need to.

An investment plan can change over time as your goals change, and you learn more about investing. Be willing to adapt when necessary.

As you go through this process methodically rather than emotionally, you’ll have a better chance of reaching your goals.