In 1976, the late founder and chairman of Vanguard Group, John “Jack” Bogle, upended Wall Street’s fund managers by launching the first commercially viable index mutual fund, called the First Index Investment Trust. This low-cost vehicle provided investors with exposure to the returns of the S&P 500 index and paved the way for the mutual fund industry’s boom.
On Jan. 22, 1993, the mutual fund industry was disrupted by the launch of the first U.S. exchange-traded fund, or ETF: the SPDR S&P 500 ETF (ticker: SPY). The launch of SPY heralded a new era of widespread ETF adoption among institutional and retail investors alike. Today, SPY enjoys a massive $380 billion in assets under management.
Today, investors can use both index funds and ETFs to build a low-cost, broadly diversified investment portfolio. That being said, each has unique advantages and disadvantages, so knowing the ins and outs is essential. Here’s what the experts have to say about the similarities and differences between ETFs and index funds, based on different factors:
— Similarities.
— Mechanics.
— Trading.
— Fees.
— Tax efficiency.
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Similarities
“It’s definitely semantics, but for an uninitiated investor I think it’s helpful to understand that both mutual funds and ETFs can track an underlying index,” says Kaleb Paddock, founder and certified financial planner at Ten Talents Financial Planning. From an investment objective perspective, both fund structures can provide the same end results.
As Jon Maier, chief investment officer at Global X ETFs, notes: “Index funds are simply a type of ETF or mutual fund that attempt to track the returns of a benchmark index.” Both achieve this objective by buying and holding the underlying securities in an index to replicate its performance.
“For example, the Vanguard 500 Index Fund is available in both ETF (VOO) and mutual fund (VFIAX) form,” says Rodney Comegys, global head of Vanguard’s Equity Indexing Group. “Both offer exposure to the same index, have low costs and operate under the same regulatory structure. From an investment perspective, there is little difference between VOO and VFIAX.”
However, looking beyond investment objectives is where ETFs and index funds begin to diverge. The major differences relate to fund mechanics, trading, fee structure and tax-efficiency.
[Read: Guide to Mutual Funds]
Mechanics
Index mutual funds are priced once at the end of the day based on their net asset value, or NAV.
“The NAV of an index fund is calculated by dividing its total net assets by the total number of units outstanding,” says Rick Nott, senior wealth advisor at Lourd Murray in Beverly Hills, California. Thus, the NAV of an index mutual fund is what investors are buying or selling units for at the end of a day.
ETFs have a NAV calculated in the same way, but also a secondary market price. Unlike mutual fund units, ETF shares trade openly on exchanges throughout the day. Thus, their market price can fluctuate based on supply and demand. Occasionally, an ETF’s price can diverge from its NAV to trade at a premium or discount due to heavy buying or selling pressure.
To remedy this, ETFs use a “creation and redemption” mechanism facilitated by authorized participants and ETF sponsors. These two parties continually buy or sell the underlying securities in an ETF to create or redeem ETF shares, which helps to meet supply and demand. This mechanism helps ensure liquidity and usually arbitrages away any premiums or discounts to NAV.
Trading
The largest difference between ETFs and index funds relates to how they’re traded.
“While index funds can only be bought and sold at the end of the trading day through a fund manager, ETFs are traded on exchanges and trade throughout the day like stocks,” says Maier. Accordingly, the share price of an ETF is updated throughout the trading day based on activity.
Which one to pick depends on an investor’s objectives. “Investors who value the flexibility to trade in real time with a variety of order types might prefer ETFs, while investors who prefer the simplicity of buying and selling shares only at the daily closing NAV might prefer a mutual fund,” says Comegys.
Other important differences include investment minimums. “For example, Vanguard mutual funds typically have a minimum initial investment of $3,000, while a Vanguard ETF can be purchased for as little as the price of one share,” says Comegys.
It’s also more difficult to automate ETFs’ purchase amounts, as their price will fluctuate throughout the day, with the minimum purchase requirement being the price of a single share. On the other hand, most index mutual funds allow for automated recurring purchases at the end of the day in any amount.
There’s also the behavioral aspect to consider. Because ETFs trade like stocks, some investors may be tempted to time the market. “From a psychology standpoint, index funds may be a better option for many investors because they don’t price until the end of the day,” says Nott. “If the market crashes, you won’t see the impact until after market close, which may save investors from panic-selling.”
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Fees
“One of the primary benefits of index funds are their fees compared to actively managed funds,” says Maier. Thanks to stiff competition and economies of scale, both index mutual funds and ETFs currently sport some of the lowest fees across the fund management industry.
Both types of funds charge an expense ratio, which is expressed as a percentage deducted from the total amount invested in a fund. For example, VOO charges a 0.03% expense ratio. An investor who buys $10,000 worth of VOO can expect to pay around $3 in annual fees. The expense ratio is determined by the fund’s management fee plus additional operating, marketing and administrative expenses.
Some index mutual funds also carry additional fees in the form of loads. These are additional sales charges or commissions that may be levied by a third party, such as a financial advisor or broker. While increasingly uncommon, loads still exist, which makes it important to screen for them.
In contrast, additional ETF fees tend to center around trading costs. This includes brokerage commissions and slippage from the bid-ask spread.
Tax Efficiency
Finally, ETFs and index funds have differences when it comes to tax efficiency. While both are more tax-efficient than actively managed funds thanks to their comparatively lower turnover, ETFs overall have an advantage due to their unique structure and mechanism.
“ETFs may be more tax-efficient than index funds due to the creation and redemption mechanism,” says Nott.
When investors sell units in a mutual fund, the manager must sell some of the underlying securities to cover the redemptions. If the securities are sold above their cost basis, a taxable event occurs, with capital gains passed onto investors annually.
In contrast, ETF investors can simply sell their shares to other investors over an exchange, thus controlling when they incur capital gains. If there is enough selling pressure for an ETF, an authorized participant can buy ETF shares and redeem them with the ETF sponsor for the underlying securities in an “in-kind” transaction, thus avoiding a sale and capital gains.
That being said, tax efficiency is ultimately dependent on the fund’s underlying asset. Index ETFs and index funds tracking assets like real estate investment trusts, or REITs, and bonds tend to be less tax-efficient than those tracking U.S. equities. The solution for this is smart asset allocation, which can be achieved by placing less tax-efficient funds in a tax-sheltered account like a Roth IRA.
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ETF vs. Index Fund: The Difference and Which to Use originally appeared on usnews.com
Update 01/30/23: This story was previously published at an earlier date and has been updated with new information.
