Investors aiming to tap into the performance of dominant stock market indexes like the S&P 500 today are presented with two primary vehicles: exchange-traded funds, or ETFs, and traditional mutual funds. A prime illustration of this choice is seen in the offerings from Vanguard.
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“For example, the Vanguard 500 Index Fund is available in both ETF (ticker: 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.”
VFIAX is a mutual fund that tracks the S&P 500 Index and requires a minimum investment of $3,000. On the other hand, VOO is an ETF that tracks the S&P 500 and trades at about $454 per share as of early February. Both options promise affordable, transparent and easily accessible ways to invest in the S&P 500.
“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.
In other words, index funds can be both mutual funds and ETFs, but not all ETFs and mutual funds are index funds — some are actively managed instead of tracking an index.
As Jon Maier, chief investment officer at Global X ETFs notes: “Index funds are simply a type of ETF or mutual fund that attempts to track the returns of a benchmark index.”
However, there are still quite a few essential differences between ETFs and index mutual funds that investors should be aware of. Understanding these distinctions is crucial in making an informed decision about which investment vehicle is more suited to an individual’s financial goals and investing style.
Here’s a look at the most important factors to weigh when deciding between an ETF and an index mutual fund, according to experts:
— Similar mechanics.
— Trading differences.
— Fees and costs.
— Tax efficiency.
Similar Mechanics
Both ETFs and mutual funds can track an index, which is a collection of stocks (or other assets) selected based on a specific, rules-based methodology. These indexes often aim to represent a particular market segment or the market as a whole.
The S&P 500 Index, for instance, includes 500 leading publicly traded U.S. companies, chosen based on criteria set by a governing committee to reflect the broader U.S. equity market.
To track the performance of an index, ETFs and mutual funds can either fully replicate its constituents or sample the most significant and representative parts.
Full replication involves buying all the stocks in the index in their exact proportions, while sampling involves purchasing a subset of stocks that represent the broader characteristics of the index. Sampling is often used to avoid including illiquid constituents that might be difficult or expensive to trade.
When investors buy shares of an ETF or units of a mutual fund, they get proportional exposure to the stocks within the underlying index. This means investors indirectly own a piece of each stock in the index, allowing them to benefit from its returns and share in its risks.
However, one important aspect to be aware of is tracking error. This refers to the difference between the returns of the ETF or mutual fund and the returns of the index it aims to replicate.
Tracking error is a common phenomenon, as the ETF or mutual fund will typically lag behind the index due to trading costs, fees and other expenses. It impacts the accuracy with which the ETF or mutual fund mirrors the index’s performance over the long term.
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Trading Differences
The trading mechanics of ETFs and mutual funds, including those that track an index, mark a significant point of divergence between the two investment vehicles.
Mutual funds are traded based on their net asset value, or NAV, which is calculated once per day. The NAV is determined by taking the total net assets of the fund, subtracting any liabilities, and then dividing by the number of units outstanding.
This means that all investors buying into or selling out of a mutual fund on a given day receive the same price based on the NAV, which is set after the market closes. This daily pricing reflects the mutual fund’s value at the end of the trading day, ensuring that all transactions are executed at this single price.
On the other hand, ETFs operate differently. “While index mutual 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.
While ETFs also have a NAV calculated in much the same way as mutual funds, their trading involves a market price that can vary from the NAV. This discrepancy can lead to situations where the ETF trades at a premium or discount relative to its NAV.
To manage this and ensure that the market price of an ETF closely aligns with its NAV, ETF sponsors and authorized participants engage in a process known as “creation and redemption.”
This mechanism allows for the adjustment of the supply of ETF shares in the market, facilitating arbitrage opportunities that help bring the ETF’s market price back in line with its NAV.
Authorized participants, or APs, which are typically large financial institutions, play a crucial role here. They have the ability to directly interact with the ETF provider to create new shares or redeem them in large blocks, usually in exchange for the delivery of the underlying assets or cash.
This two-way process acts as a balancing force, mitigating the potential for significant premiums or discounts to the NAV and ensuring the ETF trades at a price that aligns closely with its NAV.
“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.
Fees and Costs
Both index ETFs and index mutual funds offer the advantage of low fees, a direct result of the low turnover of their index benchmarks and the efficient management of their portfolios.
This efficiency comes from the fact that these funds are not actively managed; there’s no manager tasked with selecting and managing a portfolio of stocks based on their own research or strategies. Instead, both vehicles aim to replicate the performance of a benchmark index, which can be done systematically and with minimal intervention.
Index ETFs and mutual funds both incur an expense ratio, which is expressed as an annual percentage of the fund’s average net assets. For instance, VOO has an expense ratio of 0.03%, while VFIAX charges 0.04%. On a $10,000 investment, these expense ratios translate to annual fees of $3 and $4, respectively.
However, the total cost of ownership extends beyond just the expense ratio. For ETFs, an additional consideration is the bid-ask spread — the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask).
This spread can impact the cost of buying and selling ETF shares, especially for those that are less liquid. Choosing ETFs with a high degree of liquidity and low bid-ask spreads, sometimes as minimal as 0.01%, can help minimize these costs.
On the mutual fund side, some funds may charge loads, which are essentially sales charges or commissions. These fees are becoming less common but are still a factor to consider, as they can significantly increase the cost of investment in mutual funds.
Moreover, some mutual funds may have minimum investment requirements, which can be a barrier for some investors. ETFs, in contrast, do not have such minimums — investors can purchase as little as a single share, making them more accessible, especially with brokerages that offer fractional trading.
“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.
Tax Efficiency
Finally, the most significant advantage ETFs have over mutual funds, including index variants, is their tax efficiency. This efficiency stems largely from the creation and redemption mechanism inherent to ETFs.
“For example, while it is not guaranteed in the future, both the Invesco QQQ Trust (QQQ) and the Invesco Nasdaq 100 ETF (QQQM) have not paid a capital gains distribution to shareholders since their inceptions,” says Paul Schroeder, QQQ strategist at Invesco. “The two primary drivers of this efficiency have been the experience of the portfolio management team and the ETFs’ ability to utilize the in-kind creation and redemption process.”
In the case of mutual funds, when an investor decides to sell their units, the fund’s portfolio manager may need to sell a proportionate amount of the fund’s holdings to meet the redemption.
This sale of securities can trigger capital gains, which are then distributed across all of the fund’s investors, leading to potential tax liabilities for them — even for those who didn’t sell any shares.
ETFs operate differently, enhancing their tax efficiency. Because ETF shares are bought and sold on exchanges, similar to stocks, transactions occur directly between buyers and sellers. If there’s a need to sell a large number of ETF shares, an authorized participant can step in to facilitate the transaction.
Hence, the AP can buy the ETF shares and redeem them with the ETF sponsor in exchange for the underlying assets of the ETF. This process, known as an “in-kind” transaction, allows for the exchange of ETF shares for securities without the need to sell the underlying stocks. As a result, it avoids triggering capital gains taxes that would be passed on to investors.
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ETF vs. Index Fund: The Difference and Which to Use originally appeared on usnews.com
Update 02/06/24: This story was previously published at an earlier date and has been updated with new information.
