Exchange-traded funds, or ETFs, and index funds are very popular with investors nowadays; both offer advantages over actively managed mutual funds. 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.

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. Because it basically duplicates its index's moves, an index fund can be passively managed; no fund managers have to be making active decisions about where and how to invest, in other words.

The two primary advantages of passively managed index funds over actively managed mutual funds are (1) lower management expense ratios, which are typically one-half to two-thirds less than regular funds' management fees 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's traded in the same way as an individual stock (that is, its price changes throughout the day as shares are bought and sold; 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 (see "A Brief History of Exchange-Traded Funds). 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; ETFs are even exempt from the uptick rule on short selling that applies to stocks. 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; by buying and selling in "like-kind exchanges," ETFs avoid a taxable event, which 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. However, this can be a disadvantage in terms of transaction costs, since buying ETFs means paying a brokerage commission.
  • 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.