What's the difference between an index fund and an ETF?
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.
An index fund is a type of mutual fund that is designed to track a particular market “index”, whether it is the S&P 500, Russell 2000, or MSCI EAFE; hence the name “index fund”. Due to the nature of their design (mimicking a specific market index), index funds would be considered a passive management strategy, which have a lower cost structure than typical mutual funds. Typical mutual funds are actively managed, and are built to outperform a particular benchmark or address a specific investment strategy.
An Exchange Traded Fund (ETF) would also be considered a passive investment strategy. ETFs can track an index, an industry, a commodity, a particular investment strategy, ect. They are listed on market exchanges just like individual stocks; which allow them to be bought and sold like a stock. Their prices can go up and down like stock prices throughout the day, and they provide liquidity like highly traded securities.
Both are fund structures with many similar regulations. The main differences between ETFs and mutual funds are pricing and trading.
Mutual funds are only purchased and sold at the end of the day, after the Net Asset Value (NAV) of the underlying portfolio of securities is determined, and are thereby always priced at exactly NAV. Mutual funds incur no additional cost due to a bid/ask spread or possibility of trading at a premium or a discount.
Exchange-traded funds (ETFs) are pooled investment vehicles that can be traded on the stock exchange like a single stock. Similar to stocks, ETF shares are priced and traded continuously throughout the day, with their price determined by investor demand. As a result, ETF shares could be priced higher or lower than their underlying securities’ values, known as the fund’s net asset value (NAV).
ETFs and mutual funds both have internal expenses (expense ratios) so in comparing similar funds, it remains important to compare fees. Both structures can have equally low fees. For example, Vanguard's equivalent ETF and indexed mutual fund have the same fee.
While ETFs provide intra-day liquidity for investors who trade often, long-term investors who do not have a need for this benefit can achieve the same result by using open-ended mutual funds with similar features. By using mutual funds, an investor avoids the need to monitor bid-ask spreads and premiums/discounts of an ETF.
Learning investing basics includes understanding the difference between an index fund and an exchange-traded fund, or ETF. First, ETFs are considered more flexible and more convenient than index funds. ETFs can be traded more easily than index funds and traditional mutual funds, similar to how common stocks are traded on a stock exchange. In addition, investors can also buy ETFs in smaller sizes and with fewer hassles than index funds. By purchasing ETFs, investors can avoid the special accounts and documentation required for index funds, for example.
Other differences between index funds and ETFs relate to the costs associated with each one. Typically, there are no shareholder transaction costs for index funds. Costs such as taxation and management fees, however, are lower for ETFs. Most passive retail investors choose index funds over ETFs based on cost comparisons between the two. Passive institutional investors, on the other hand, tend to prefer ETFs. Investors can purchase ETFs that represent a particular index such as the Wilshire 5000 Total Market Index.
Compared to value investing, index fund investing is considered by financial experts as a rather passive investment strategy. Both of these types of investing are considered to be conservative, long-term strategies. Value investing often appeals to investors who are persistent and willing to wait for a bargain to come along. Getting stocks at low prices increases the likelihood of earning a profit in the long run. Value investors question a market index and usually avoid popular stocks in hopes of beating the market.
Other advisors noted the technical difference but make sure of one thing!
DON'T CONFUSE INDEX FUNDS AND/OR ETFs WITH LOW RISK! In fact, mirroring the market may often lead to taking on more investment risk than you expect. Especially at a time when market prices are relatively high.