ETFs vs. Index Mutual Funds: An Overview

Both exchange-traded funds (ETFs) and index mutual funds are popular forms of passive investing, a term for an investment strategy that aims to match—not beat—the performance of a benchmark. Such passive strategies may use ETFs and index mutual funds to replicate the performance of a financial market index, such as the S&P 500 Index.

Active investing strategies require expensive portfolio management teams that try to beat stock market returns and take advantage of short-term price fluctuations.

Of note, passive strategies that involve ETFs and index mutual funds have grown dramatically in popularity versus active strategies. That's not only due to the cost benefits of lower management fees, but also to higher returns on investment.

Index investing has been the most common form of passive investing since 1976, when Jack Bogle, founder of Vanguard, created the first index mutual fund.

The market for ETFs (the second most popular form of passive investing) has grown significantly since they were first launched in the 1990s as a way to allow investment firms to create “baskets” of major stocks aligned to a specific index or sector.

Both ETFs and index mutual funds are pooled investment vehicles that are passively managed. The key difference between them (discussed below) is that ETFs can be bought and sold on the stock exchange (just like individual stocks)—and index mutual funds cannot.

The investing strategy behind an index fund—whether ETF or mutual fund—is that a portfolio that matches the composition of a certain index (without variation) will also match the performance of that index. Moreover, the overall market will outperform any single investment over the long term.

Exchange-Traded Funds

Diversification

In particular, an ETF is comprised of a portfolio of stocks, bonds, or other securities of a particular index and tracks the returns of that index. For example, ETFs can be structured to track a particular broad market index or a sector, an individual commodity or a diverse collection of securities, a specific investment strategy, or even another fund.

An ETF offers investors major diversification by providing exposure to a wide range of assets.

Intraday Trading

Unlike index mutual funds, ETFs are flexible investment vehicles that are highly liquid. They can be bought and sold on a stock exchange throughout the trading day, just like individual stocks.

Because investors can enter or exit an ETF position whenever the market is open, ETFs are attractive to a broad range of the investing public, including active traders (like hedge funds) as well as passive investors (like institutional investors).

Derivatives

Another reason why ETFs attract passive and active investors is that certain ETFs include derivatives—a financial instrument whose price is derived from the price of an underlying asset.

The most common ETFs that invest in derivatives are those that hold futures—agreements between buyer and seller to trade certain assets at a predetermined price on a predetermined future date. Other such ETFs may invest in options.

Available at a Brokerage

Another benefit of ETFs is that—because they can be traded like stocks—it is possible to invest in them with a basic brokerage account. There is no need to create a special account, and they can be purchased in small batches without special documentation or rollover costs.

Index Mutual Funds

Similar to an ETF, an index mutual fund is designed to track the components of a financial market index. Index mutual funds must follow their benchmarks passively, without reacting to market conditions. Orders to buy or sell them can be executed only once a day after the market closes. An index mutual fund can track any financial market, such as:

• The S&P 500 (the most popular in the U.S.)
• The FT Wilshire 5000 Index (the largest U.S. equities index)
• The Bloomberg Aggregate Bond Index
• The MSCI EAFE Index (European, Australasian, and Middle Eastern stocks)
• The Nasdaq Composite Index
• The Dow Jones Industrial Average (DJIA) (30 large-cap companies)

For example, an index mutual fund tracking the DJIA invests in the same 30 companies that comprise that index—and the fund portfolio changes only if the DJIA changes its composition.

If an index mutual fund is following a price-weighted index—an index in which the stocks are weighted in proportion to their price per share—the fund manager will periodically rebalance the securities to reflect their weight in the benchmark.

Potential for Strong Returns

Although they are less flexible than ETFs, index mutual funds can deliver the same strong returns over the long term.

Easy Accessibility

Another benefit of index mutual funds that makes them ideal for many buy-and-hold investors is their ease of access. For example, index mutual funds can be purchased through an investor’s bank or directly from the fund. There's no need for a brokerage account. This accessibility has been a key driver of their popularity.

Key Differences

Certain features of each type of fund (described above) result in index mutual funds being less liquid than ETFs and lacking ETFs' intraday trading flexibility.  In addition, different factors related to index tracking and trading give ETFs a cost and potential tax advantage over index mutual funds:

• For example, ETFs don't have the redemption fees that some index mutual funds may charge. Redemption fees are paid by an investor whenever shares are sold.
• Additionally, the constant rebalancing that occurs within index mutual funds results in explicit costs (e.g., commissions) and implicit costs (trade fees). ETFs avoid these costs by using in-kind redemptions rather than monetary payments for exited securities. This strategy can limit capital gains distributions for shareholders (but of course, capital gains taxes may still be owed when investors themselves sell their shares).
• ETFs have less cash drag than index mutual funds. A cash drag is a type of performance drag that occurs when cash is held to pay for the daily net redemptions that happen in mutual funds. Cash has very low (or even negative) real returns due to inflation, so ETFs—with their in-kind redemption process—are able to earn better returns by investing all cash in the market.
• ETFs are more tax efficient than index funds because they are structured to have fewer taxable events. As mentioned previously, an index mutual fund must constantly rebalance to match the tracked index and therefore generates taxable capital gains for shareholders. An ETF minimizes this activity by trading baskets of assets. In turn, this limits exposure to capital gains on any individual security in the ETF portfolio.

Special Considerations

The benefits and drawbacks of ETFs versus index mutual funds have been debated in the investment industry for decades, but—as always with investment products—the choice of one over the other depends on the investor. Typically, it comes down to preferences related to management fees, shareholder transaction costs, taxation, and other qualitative differences. Despite the lower expense ratios and tax advantages of ETFs, many retail investors (non-professional, individual investors) prefer index mutual funds. They like their simplicity and their shareholder services (such as phone support and check writing) as well as investment options that facilitate automatic contributions.

While increased awareness of ETFs by retail investors and their financial advisers has grown significantly, the primary drivers of demand have been institutional investors seeking ETFs as convenient vehicles for participating in (or hedging against) broad movements in the market.

The convenience, ease, and flexibility of ETFs allow for the superior liquidity management, transition management (from one manager to another), and tactical portfolio adjustments that are cited as the top reasons institutional investors use ETFs.

The Bottom Line

ETFs and index mutual funds can be two smart choices for investors saving for the long run. Both are used in passive investing strategies. The biggest difference between them is that ETFs trade intraday at various prices during exchange hours and index mutual funds can be bought or sold only after the market closes each day, at a fund's net asset value.