Exchange-traded funds, or ETFs, and index funds are very popular with investors nowadays. Both offer advantages over mutual funds. that are actively managed. The question of whether to include them in your investment portfolio is largely decided by whether they suit your personal investment style, strategy, and goals.

Key Takeaways

  • ETFs and index funds generally have lower fees compared with actively managed mutual funds.
  • Index funds historically have outperformed actively managed mutual funds.
  • However, a handful of actively managed mutual funds offer significantly higher returns compared with index funds, which lack the flexibility to earn gains above market averages.

What's an Index Fund?

Index funds are mutual funds designed to mirror the performance of a market index such as the S&P 500 Index. Because it basically duplicates its index's moves, an index fund can be passively managed. In other words, no fund managers have to be making active decisions about where and how to invest.

The two primary advantages of passively managed index funds over actively managed mutual funds are: (1) lower management expense ratios (0.71% for actively managed funds in 2020 vs. 0.06% for index funds, and (2) the fact that index funds have historically outperformed the majority of actively managed funds.

However, there are some actively managed funds that generate significantly higher investment returns than index funds. The primary disadvantage of index funds is the lack of flexibility that automatically precludes them from ever being able to make dramatic gains over and above average market performance.

What's an ETF?

An ETF is an equity investment. Constructed to track a commodity, index, market sector, or basket of assets, it's a fund that is traded in the same way as an individual stock. That is, its price changes throughout the day as shares are bought and sold, whereas mutual funds' shares have their price set once a day. ETFs have skyrocketed in popularity with investors since their appearance on the investment stage in the 1990s.

The comparison of ETFs to mutual funds involves several factors, but among notable advantages, ETFs offer the following:

  • As they can be traded like stocks, ETFs offer the advantage of being more liquid. They can be bought or sold any time during trading hours. They are more flexible. They can be sold short. They can also be purchased on margin, bought with limit orders, and hedged with options.
  • ETFs have lower management fees.
  • They are more favorable in regard to taxes. Instead of buying and selling portfolio assets, which would create a taxable event, ETFs usually require Authorized Participants to redeem shares in-kind. This avoids the daily redemption costs that funds incur and minimizes capital gains taxes.
  • ETFs are more accessible to small investors because they allow the purchase of individual shares, while many mutual funds have minimum investments of $2,500 or more.
  • ETFs provide easier access to alternative investments, creating a broader range of investment opportunities. There are ETFs that invest in commodities and foreign exchange currencies, and offer the ability to invest extensively in international and emerging markets.

One drawback of ETFs is that they cannot reinvest dividends as mutual funds can.

Comparing ETFs and Index Funds

Index funds are generally more suited to less sophisticated, more risk-averse investors who have longer-term investment horizons. For example, those who are using equity investing as part of a retirement plan and prefer to keep things simple, minimize investment costs and look to make reasonable profits, benefiting from the historical trend of stock values to increase over time.

ETFs are more appealing to investors with more hands-on investment styles, those aggressively seeking higher short-term returns on investments and sophisticated investors who desire greater access to alternative investments such as the forex market and futures.