What's the difference between an index fund and an ETF?

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April 2017
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The differences between an indexed mutual fund and an exchange-traded fund (ETF) are subtle, but can be important. Most indexed mutual funds are low cost. There are exceptions to the rule. Mutual funds that track the S&P 500 have management fees that range from 0.03% to over 0.50%. That adds up over several years. Indexed ETFs all almost uniformly competitive with the cheapest index mutual funds. 

The security structure of mutual funds and ETFs is different. Mutual funds are marked to market once a day, after close of market. They are priced at the net asset value (NAV) of the underlying holdings. ETFs trade continuously throughout the day like stocks. Their bid ask spread reflects the overall trading volume in the ETF plus a risk premium that dealers require to make a market in a security that may have illiquid underlying assets. 

Mutual fund managers must retain cash balances to satisfy share redemptions. Thus, some of the investor money sits idly. On the other hand, the number of ETF shares is fixed in the short term. Almost all of the ETF value is invested in the index.

ETF shares are created and redeemed by authorized participants (APs) in exchange for the market basket of underlying securities. This feature allows the ETF issuer to manage the cost basis of the inventory they deliver during the redemption of shares. Bottom line, equity ETFs are more tax efficient than equity mutual funds. SPY, for example, has paid virtually no capital gains distributions in its 20+ year lifespan. 

Some ETFs do pose a disadvantage relative to mutual funds. Prices of the less liquid ETFs can deviate materially from their NAV. Moreover, bid/ask spreads can be substantial with these less liquid ETFs. The mark to market feature of the traditional open-ended mutual fund does insulate investors from trading anomalies like this. Thus, investors should be careful in placing orders for some of the smaller ETFs in the marketplace.

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