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