ETFs vs. Index Mutual Funds: What’s the Difference?

ETFs vs. Index Mutual Funds: An Overview

Both exchange-traded funds (ETFs) and index mutual funds are popular forms of passive investing, a term for an investment strategy that aims to match—not beat—the performance of a benchmark. Such passive strategies may use ETFs and index mutual funds to replicate the performance of a financial market index, such as the S&P 500 Index.

Active investing strategies require expensive portfolio management teams that try to beat stock market returns and take advantage of short-term price fluctuations. Passive strategies that involve ETFs and index mutual funds have grown dramatically in popularity versus active strategies due not only to the cost benefits of lower management fees, but also to higher returns on investment.

Index investing has been the most common form of passive investing since 1976 when Jack Bogle, founder of Vanguard, created the first index mutual fund.

The market for ETFs has grown significantly since they were first launched in the 1990s as a way to allow investment firms to create “baskets” of major stocks aligned to a specific index or sector.

Both ETFs and index mutual funds are pooled investment vehicles that are passively managed. The key difference between them is that ETFs can be bought and sold on the stock exchange, just like individual stocks, and index mutual funds cannot.

The investing strategy behind an index fund, whether it’s an ETF or a mutual fund, is that a portfolio that matches the composition of a certain index without variation will also match the performance of that index. The overall market will outperform any single investment over the long term.

Exchange-Traded Funds

Diversification

An ETF is a portfolio of stocks, bonds, or other securities of a particular index and it tracks the returns of that index. ETFs can be structured to track a particular broad market index or a sector, an individual commodity or a diverse collection of securities, a specific investment strategy, or even another fund.

An ETF offers investors major diversification by providing exposure to a wide range of assets.

Intraday Trading

Unlike index mutual funds, ETFs are flexible investment vehicles that are highly liquid. They can be bought and sold on a stock exchange throughout the trading day just like individual stocks.

Investors can enter or exit an ETF position whenever the market is open so ETFs are attractive to a broad range of the investing public, including active traders like hedge funds as well as passive investors such as institutional investors.

Derivatives

Another reason why ETFs attract both passive and active investors is that certain ETFs include derivatives, a financial instrument whose price is derived from the price of an underlying asset.

The most common ETFs that invest in derivatives are those that hold futures: agreements between a buyer and seller to trade certain assets at a predetermined price on a predetermined future date. Other such ETFs may invest in options.

Available at Brokerages

Another benefit of ETFs is that it’s possible to invest in them with a basic brokerage account because they can be traded like stocks. There’s no need to create a special account and they can be purchased in small batches without special documentation or rollover costs.

Index Mutual Funds

An index mutual fund is designed to track the components of a financial market index, similar to an ETF. Index mutual funds must follow their benchmarks passively without reacting to market conditions. Orders to buy or sell them can be executed only once a day after the market closes.

An index mutual fund can track any financial market, including:

An index mutual fund tracking the DJIA invests in the same 30 companies that make up that index and the fund portfolio changes only if the DJIA changes its composition.

The fund manager will periodically rebalance the securities to reflect their weight in the benchmark if an index mutual fund is following a price-weighted index in which the stocks are weighted in proportion to their price per share.

Potential for Strong Returns

Index mutual funds are less flexible than ETFs, but they can deliver the same strong returns over the long term.

Easy Accessibility

Another benefit of index mutual funds that makes them ideal for many buy-and-hold investors is their ease of access. Index mutual funds can be purchased through an investor’s bank or directly from the fund. There’s no need for a brokerage account. This accessibility has been a key driver of their popularity.

Key Differences

Certain features of each type of fund result in index mutual funds being less liquid than ETFs and lacking ETFs’ intraday trading flexibility. Different factors related to index tracking and trading also give ETFs a cost and potential tax advantage over index mutual funds:

• ETFs don’t have the redemption fees that some index mutual funds may charge. Redemption fees are paid by an investor whenever shares are sold.
• The constant rebalancing that occurs within index mutual funds results in explicit costs such as commissions as well as implicit costs like trade fees. ETFs avoid these costs by using in-kind redemptions rather than monetary payments for exited securities. This strategy can limit capital gains distributions for shareholders, but capital gains taxes may still be owed when investors themselves sell their shares.
• ETFs have less cash drag than index mutual funds. A cash drag is a type of performance drag that occurs when cash is held to pay for the daily net redemptions that happen in mutual funds. Cash has very low or even negative real returns due to inflation, so ETFs can earn better returns by investing all cash in the market with their in-kind redemption process.
• ETFs are more tax-efficient than index funds because they’re structured to have fewer taxable events. An index mutual fund must constantly rebalance to match the tracked index and therefore generates taxable capital gains for shareholders. An ETF minimizes this activity by trading baskets of assets. This limits exposure to capital gains on any individual security in the ETF portfolio.

Special Considerations

The benefits and drawbacks of ETFs versus index mutual funds have been debated in the investment industry for decades, but the choice of one over the other depends on the investor, as always with investment products. It typically comes down to preferences related to management fees, shareholder transaction costs, taxation, and other qualitative differences.

Many non-professional, individual investors prefer index mutual funds despite the lower expense ratios and tax advantages of ETFs. They like their simplicity and their shareholder services such as phone support and check writing as well as investment options that facilitate automatic contributions.

While increased awareness of ETFs by retail investors and their financial advisers has grown significantly, the primary drivers of demand have been institutional investors seeking ETFs as convenient vehicles for participating in or hedging against broad movements in the market.

The convenience, ease, and flexibility of ETFs allow for the superior liquidity management, transition management from one manager to another, and tactical portfolio adjustments that are cited as the top reasons institutional investors use ETFs.

The Bottom Line

ETFs and index mutual funds can be two smart choices for investors who are saving for the long run. Both are used in passive investing strategies.

The biggest difference between them is that ETFs trade intraday at various prices during exchange hours and index mutual funds can be bought or sold only after the market closes each day at a fund’s net asset value.