Investment may be either active or passive. With the former approach, the investor purchases, holds, and sells marketable securities in pursuit of a particular objective. His or her decision is a function of fundamental research on the company in the context of its industry, in particular, and of the national and global economy, in general. The latter approach, by contrast, entails replicating a benchmark or index of marketable securities that share common traits.
Active investors believe that they can best the market and earn alpha. Passive investors, on the other hand, maintain that market inefficiencies over the long term get ironed out ("arbitraged away," in the parlance of market professionals), so attempting to beat the market is fruitless. These sorts of investors simply desire to achieve beta or the market return. (See also: Benchmark Your Returns With Indexes)
For the typical individual investor, passive investment is best accomplished through professional management. Two choices exist: the open-end investment company, otherwise known as the mutual fund, and the exchange-traded fund or ETF. Because both types of funds track an underlying index, differences in performance typically lie in the tracking error or degree to which the fund fails to replicate the index.
Additionally, the cost of an ETF can be lower than its open-ended counterpart, a difference that can affect performance, as well. Another important consideration that bears on performance is investor behavior. What follows is a basic discussion of the main attributes of each and under what circumstances one would use them.
The Truly Passive Investor
This individual wants to achieve an asset allocation best suited to his or her objectives at a low cost and with minimal activity. For him or her, the index mutual fund would be preferable. A typical adjustment in exposure would be achieved through rebalancing on a regularly scheduled basis to maintain consistency with his or her goal. Should circumstances change the adjustment of one's allocation or one-off, then tactical changes are easily accomplished.
The (At Times) Not So Passive Investor
This individual shares many of the goals of the truly passive investor, but may exhibit greater sophistication and want to effect changes in his or her portfolio with greater speed and precision. For this type of investor, the ETF would be more appropriate. While taking the passive approach, like its older mutual fund cousin, the ETF allows the holder to take and implement a directional view on the market or markets in ways that the open-ended fund cannot. For example, as with shares of common stock, ETFs trade in the secondary market. Investors may purchase and sell them during market hours, rather than be dependent upon forward pricing, where the traditional mutual fund's price is calculated at net asset value (NAV) after the market close.
Additionally, investors may short sell an ETF. The passive investor who may be opportunistically inclined will relish the greater flexibility that this vehicle affords - tactical changes and market plays may be executed rapidly. The one potential disadvantage is the accumulation of trading costs as a function of one's trading activity. Using ETFs in the aforementioned way is an active application of a passive investment.
The investor should understand market dynamics as they affect asset class behavior and be able to understand and justify their decision-making process, not forgetting that trading costs can reduce investment returns. Investors should understand that attempting to practice the hedge fund strategy of global macro (taking directional bets on asset classes to achieve outsized returns) is akin to a marksman attempting to achieve the range and precision of a high-powered rifle with a .22 caliber gun.
Notwithstanding the foregoing discussion, there are several other features of which individual investors should make note when deciding whether to use an index mutual fund or index ETF. Mutual funds have different share classes, sale charge arrangements and holding period requirements to discourage rapid trading. The investor's time frame and (dis)inclination to trade will dictate what product to use. ETFs are built for speed, all else being equal, as they carry no such arrangements.
Mutual funds also often have purchase minimums that can be high, depending on the account in which one invests. Not so with exchange-traded funds. There are tax consequences, however, to investing in either a mutual fund or an ETF. The mutual fund can cause the holder to incur capital gains taxes in two ways:
When he or she sells for an amount greater than that at which he or she purchased, the investor realizes a capital gain. On the other hand, an investor may hold a mutual fund and still incur capital gains taxes if other investors in the same fund sell en masse and force the fund to sell individual holdings to raise cash for redemptions. Those sales may cause the remaining fund holders to incur a capital gain.
Finally, mutual funds offer investors dividend reinvestment programs that enable automatic reinvestment of the fund's cash dividends. In a taxable brokerage account, the dividends would be taxed, even though they're reinvested. ETFs have no such feature. Cash from dividends is placed into the brokerage account of the investor who may well incur a commission to purchase additional shares of the ETF with the dividend that it paid out. Some brokers waive any sales charge. Because of commission costs, ETFs typically do not work in a salary deferral arrangement. However, in an IRA, no tax ramifications from trading would affect the investor. (See also: What You Need to Know About Capital Gains and Taxes.)
The Bottom Line
When considering an index mutual fund versus the index ETF, the individual investor would do well to consult an experienced professional who works with individual investors of differing needs. No two individuals' circumstances are identical and the choice of one index product over another results from a confluence of circumstances. As with any investment decision, investors need to do their homework and due diligence.