What's the difference between an index fund and 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.
How Value Investing Compares
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.
Both are very low cost funds which invest in a broad index so there really isn't much difference between the two. The primary differences is that an ETF can be traded throughout the day like a stock, whereas a mutual fund can only be bought or sold at the end of the day's Net Asset Value (NAV). So an ETF is more flexible, but if you are not an active investor, it really won't make much of a difference. Active investors use ETFs. I personally would use an ETF either way just to have more flexibility.
Hope this helps and best of luck, Dan Stewart CFA®
Made popular by Vanguard, an index fund, commonly referred to as "passive investing," is really just a low-cost version of a mutual fund. Like their name sounds, an index fund is organized in a way to mimic well-known stock indices. Indices like the S&P 500, Dow Jones Industrial Average, Nasdaq 100, or Russell 3000. The way index funds are bought and sold by investors works just like a mutual fund. The good news for beginning investors is that some index funds don't have the $1,000 minimum like you see with most mutual funds. In fact, Charles Schwab allows for a $1 minimum to purchase their index funds.
Where an index fund truly differentiates itself from a mutual fund is with its cost structure. Unlike a mutual fund, index funds do not charge commissions, which is a big cost savings alone. However, the primary advantage is that index funds generally have significantly lower operating expense ratios. This is due to the passive nature of tracking an index, which requires much less overhead to run the fund and experiences a much lower frequency of internal trades.
To give you a true comparison, according to the Investment Company Institute, the average equity mutual fund charges 0.63% versus 0.09% for an equity index fund. For long-term investors, even an extra 0.54% will add up to a meaningful amount over a period of 20 years. Compound interest, or the erosion of it, only magnifies this cost differential. On the other hand, index fund expense ratios are typically higher when compared to Exchange Traded Funds (ETFs), which are discussed next. Additionally, when any one shareholder redeems their shares, it may trigger a taxable event in the form of capital gains, thereby affecting the entire group of shareholders who still remain invested with the fund.
EXCHANGE TRADED FUNDS (ETF)
Exchange Traded Funds (ETFs), offer both active and passive investing elements. Like a mutual fund, an ETF is a diversified basket of securities. However, they trade in the form of shares on the major market exchanges in real time like a stock, which makes them more nimble than a mutual fund.Meaning, ETFs are a great vehicle for active traders. Furthermore, ETFs offer more efficient exposure to alternative investments like REITs, options, commodities, and convertible securities.
In addition to passively tracking indices like the S&P 500, ETFs are able to package an investment mix that is specific to a sector style like technology or energy. Another popular type of ETF is smart beta funds. Smart beta is still technically a passive strategy in that the fund holdings are usually derived from an index, however, the difference is the fund manager will make tactical investment decisions to change the weighting of an indices stocks based on volatility and other factors. Therefore, ETFs like smart beta have an active trading aspect that deviates from the passive nature of an index fund.
From a tax standpoint, ETFs are much better than mutual funds and index funds because they don't suffer from the embedded capital gains tax issue previously discussed. This means that individual investors can better control when to realize their capital gains. Unfortunately, with mutual funds, investors are at the mercy of other shareholders and the asset manager.
Another advantage of ETFs is that they are often the lowest-cost way to diversify your investments because they carry the lowest expense ratios. For example, Vanguard's S&P 500 index fund (VFINX) has a net expense ratio of 0.14%, whereas, Vanguard's ETF version (VOO) costs 0.04%. It may sound like splitting hairs, but that's more than triple the cost for the same strategy.
Keep in mind, ETFs can be more expensive than index funds when your asset custodian charges a trading commission. The commission issue is especially problematic for low dollar amounts invested or high-frequency trading. Also, the more expensive the commission, the more mindful an investor needs to be. For instance, a $1,000 investment purchase with a $10 commission equates to a 1% fee. Now add the advisor's 1% fee and you have to make 2% just to break-even.
For a more extensive comparisons between index funds, ETFs, and mutual funds -- read about it here.
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.
An index fund is any investment fund that attempts to replicate the performance of a given index of stocks, bonds, or even a narrow subset of a financial market such as small-cap biotech companies for example. Most index funds work by identifying an already well known index, then building a fund that either owns every asset in the index or by holding similar securities. Index funds own all of the investments in that particular index, so there is less work in maintaining or managing an index fund.
An ETF is an Exchange-Traded Fund. These types of investments have been around since 1993, but they gained more attention about a decade later. Currently, the net assets held by ETFs amount to $1.34 trillion. They generally trade on the market like an individual stock. An ETF is a form of index fund, in the sense that is has the same goal; to provide investors with a benchmark return. Not all ETFs are designed to mimic index funds as some have become trading tools.
Whereas, a mutual fund is a portfolio of securities managed by a portfolio manager. These may be actively managed or passively managed (an index fund would qualify as passively managed since the portfolio manager only rebalances the index versus trading). In 1976, the first index fund was launched by the investment firm Vanguard Group. It was known as "Bogle's Folly," for John C. Bogle, the founder of Vanguard. Bogle created a fund that tracked the S&P 500. It was the Vanguard 500 (VFINX). It promised to keep up with the broad index of stocks.