When discussing investment strategies, comparing index funds and exchange-traded funds, or ETFs, often leads to confusion for beginner investors.
The term “index fund” generally refers to the strategy and management style of the investment vehicle, where the fund aims to replicate the performance of a specific benchmark, like the S&P 500. This strategy can be employed by both mutual funds and ETFs.
On the other hand, an ETF is a specific type of investment vehicle that can either passively track an index like the S&P 500 or be actively managed, allowing managers to select a portfolio of investments according to their own strategies and research.
“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.”
Therefore, while all index funds aim to mirror the performance of an index benchmark, not all ETFs or mutual funds may qualify as index funds.
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“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.
Understanding these distinctions is crucial when choosing between an ETF and an index mutual fund, as each offers different advantages and considerations.
Here’s a closer look at the most important factors to weigh when deciding between an index mutual fund and an index ETF, according to investment experts:
— Trading mechanics.
— Cost of ownership.
— Tax efficiency.
— How to choose between them.
Trading Mechanics
One of the fundamental differences between index mutual funds and index ETFs revolves around the trading mechanics of these investment vehicles.
Consider an investor looking to purchase units of VFIAX. In this case, the investor places an order specifying the amount of mutual fund units they wish to buy, and this transaction is executed only at the end of the trading day.
Mutual funds are priced once per day at their net asset value (NAV), calculated by subtracting any liabilities from the total net assets of the fund and dividing this by the number of units outstanding. Consequently, any order for a mutual fund like VFIAX will only be executed at the NAV price determined after the market closes.
Conversely, for an index ETF like VOO, the trading dynamics are quite different. Units of ETFs are traded on exchanges much like individual stocks, allowing them to be bought and sold throughout market hours using various order types, such as limit or market orders.
While ETFs also have a NAV calculated in the same manner as mutual funds, trading also involves a market price, which can fluctuate throughout the day based on supply and demand.
Despite the market price, ETFs are designed to minimize the potential discrepancies between the market price and the NAV. This is achieved through an arbitrage mechanism known as “creation and redemption,” which involves interactions between ETF sponsors and authorized participants.
For example, if an ETF is trading at a premium (higher than its NAV), an authorized participant may buy the underlying assets that make up the ETF and exchange them with the ETF sponsor for new ETF shares. These shares are then sold on the market, helping bring the market price back in line with the NAV.
Conversely, if the ETF trades at a discount (lower than its NAV), the authorized participant might purchase ETF shares on the open market and redeem them with the ETF sponsor for the underlying assets, which are then sold, again helping align the market price with the NAV.
This dynamic process ensures that ETFs, unlike closed-end funds (CEFs), which can trade at significant premiums or discounts to their NAV, maintain a closer alignment between their market price and NAV.
Cost of Ownership
Overall, both index mutual funds and index ETFs tend to have lower costs than their actively managed counterparts, primarily due to the nature of their management strategy.
These funds simply replicate an externally provided benchmark index, eliminating the need for hands-on securities research, analysis and selection that costs time, resources and money.
Index funds also tend to have lower portfolio turnover, which refers to the frequency of buying and selling assets within the fund. Lower turnover reduces costs related to trading fees, commissions and taxable capital gains events for end investors.
In general, a good way to eyeball the cost of ownership for an ETF and a mutual fund is by looking at the expense ratio, which is expressed as an annual percentage of your investment.
For instance, VFIAX charges an expense ratio of 0.04%, while VOO has an expense ratio of 0.03%. This means if you invested $10,000 in VFIAX and VOO, you would pay $4 and $3 in annual fees, respectively. These fees are deducted incrementally each day on the back end, making them almost imperceptible to investors.
However, there are additional costs to consider. For ETFs, one must account for the bid-ask spread, which is the difference between the highest price a buyer is willing to pay for an asset and the lowest price a seller is willing to accept.
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This spread should be factored into the total cost of ownership for traders. Generally, the bid-ask spread is low for index ETFs that hold liquid and heavily traded underlying assets. For VOO, those underlying assets would be stocks in the S&P 500, and the proof is in the pudding, as VOO boasts a 30-day median bid-ask spread of exactly 0%.
Conversely, mutual funds do not incur bid-ask spreads because they are not traded on an exchange. However, they have their own unique costs to watch out for.
For example, some mutual funds charge “loads,” which are additional sales charges applied at purchase or sale, depending on whether they are front-end or back-end loads. ETFs do not have load fees, though you might still pay a commission to your broker when trading ETF shares.
Additionally, mutual funds often require a minimum initial investment; for instance, VFIAX, as a Vanguard Admiral Share class fund, requires a $3,000 minimum investment.
In contrast, you can purchase shares of VOO for around $460 each, and can potentially spend even less to get exposure to the fund if your broker offers fractional shares, making it more accessible for investors starting with smaller amounts.
Tax Efficiency
When investing outside of a tax-advantaged account such as a 401(k) or Roth IRA, tax efficiency becomes an important factor to consider when deciding between an index mutual fund and an ETF.
Index mutual funds tend to be less tax-efficient primarily due to the structure of how shares are bought and sold. When investors redeem their shares, the mutual fund may need to sell securities to raise the necessary cash.
This sale can generate capital gains, which are then distributed to all fund shareholders, potentially creating a tax liability for investors even if they have not sold any shares themselves.
ETFs, on the other hand, have largely solved this problem through the use of “in-kind” transactions. Instead of selling securities to meet redemptions, ETFs can actually transfer the underlying securities directly to authorized participants in exchange for ETF shares.
This mechanism minimizes the need to sell securities, thereby reducing the realization of capital gains. As a result, capital gains distributions are minimized or eliminated entirely, significantly enhancing the tax efficiency of ETFs compared to traditional mutual funds.
“For example, while it is not guaranteed in the future, neither the Invesco QQQ Trust (QQQ) nor the Invesco Nasdaq 100 ETF (QQQM) have 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.”
How to Choose Between Them
Choosing between an index mutual fund and an ETF is largely a function of both availability and investment objectives.
For those investing inside an employer-sponsored 401(k), the options might be limited predominantly to mutual funds. In such cases, opting for an index mutual fund could be advantageous due to lower fees.
Moreover, index mutual funds tend to perform better than their actively managed counterparts over time. For instance, the latest S&P Indices Versus Active (SPIVA) study reports that 88% of U.S. large-cap funds have underperformed the S&P 500 over the last 15 years.
However, if you have access to ETFs, perhaps through a self-directed Roth IRA or a taxable brokerage account, choosing them might be preferable if you plan on frequent trading.
ETFs like VOO offer the flexibility of intraday trading, allowing investors to buy and sell throughout the day, which is particularly useful for capitalizing on trends and momentum. In contrast, a mutual fund like VFIAX can only be bought and sold once a day at the market close.
However, mutual funds offer significant advantages for those preferring a hands-off approach. They enable easy automation of periodic contributions, such as monthly or even weekly investments.
This process, known as dollar-cost averaging, is simpler with mutual funds because you purchase shares at the same price as every other investor at the end of the trading day, regardless of the order size.
On the other hand, investing in ETFs requires entering specific orders at desired prices, which can lead to variable costs unless using a market order, which might execute at an unpredictable price.
“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.
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ETF vs. Index Fund: The Difference and Which to Use originally appeared on usnews.com
Update 04/18/24: This story was previously published at an earlier date and has been updated with new information.
