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 any investment strategy that avoids the cost of an active human team by trying to match—not beat—the performance of the market. Unlike active investing strategies, which require expensive portfolio management teams focused on beating stock market returns and taking advantage of short-term price fluctuations, passive strategies like ETFs and index funds seek only to replicate the performance of a financial market index (like the ).
Of note, passive strategies like ETFs and index mutual funds have grown dramatically in popularity vs. active strategies—not only due to the cost benefits of lower management fees, but also due to higher returns on investment. Investment research firms report that few (if any) active funds perform better than passive funds over the long term.
Index investing has been the most common form of passive investing since 1975, when Jack Bogle founded Vanguard and created the first index mutual fund a year later. ETFs (the second most popular form of passive investing) have 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 (discussed below) is that ETFs can be bought and sold on the stock exchange (just like individual stocks)—and index mutual funds cannot.
- Index investing has been the most common form of passive investing since 1976, when Vanguard founder Jack Bogle created the first index fund.
- ETFs (the second most popular form of passive investing) have grown significantly since they were first launched in the 1990s.
- Because ETFs are flexible investment vehicles, they appeal to a broad segment of the investing public, including active as well as passive investors.
- Passive retail investors often choose index funds for their simplicity and low cost.
- Typically, the choice between ETFs and index mutual funds will come down to management fees, shareholder transaction costs, taxation, and other qualitative differences.
Exchange-Traded Funds (ETFs)
As a pooled investment vehicle, an exchange-traded fund (ETF) is a “basket” of stocks, bonds, or other assets that gives the investor exposure to a diverse range of assets. For example, ETFs can be structured to track anything from a particular index or sector to an individual commodity, a diverse collection of securities, a specific investment strategy, or even another fund.
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 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).
Another feature that attracts both active and passive investors is that certain ETFs include derivatives—financial instruments whose price is dependent on (a derivative of ) the price of an underlying asset. The most common ETFs involving derivatives are those that hold futures—agreements between buyer and seller to trade certain assets at a predetermined price on a predetermined future date.
Another benefit of ETFs is that—because they can be traded like stocks—it is possible to invest in ETFs 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
An index fund is any investment fund that is constructed to track the components of a financial market index typically they are either ETFs or mutual funds. Index mutual funds must follow their benchmarks without reacting to market conditions—and orders can be executed only once a day after the market closes—so they have much less liquidity and much less flexibility than ETFs.
As the original passive vehicle, the investing strategy behind an index fund (mutual fund or ETF) is that a portfolio that matches the composition of a certain index (without variation) will also match the performance of that index—and the market will outperform any single investment over the long term.
An index mutual fund can track any financial market, from the (the most popular in the U.S.) and the FT Wilshire 5000 Index (the largest U.S. equities index) to the Bloomberg Aggregate Bond Index, the MSCI EAFE Index (European, Australasian, and Middle Eastern stocks), the Nasdaq Composite Index, and 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 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.
Although they are less flexible than ETFs, index mutual funds deliver the same strong returns over the long term. Another benefit of index mutual funds that makes them ideal for many buy-and-hold investors is their easy of access. For example, index mutual funds can be purchased through an investor’s bank or directly from the fund, with no need for a brokerage account—and this accessibility has been a key driver of their popularity.
In addition to the flexibility and liquidity differences noted earlier, ETFs and index mutual funds have a few significant cost differences. Compared to actively managed funds, both these passive vehicles are low-cost investment options, but each has cost advantages and disadvantages associated with their different approaches to index tracking and trading, including redemptions, cost drag, dividend policy, and taxation. Overall, the structural differences between the two investment vehicles give ETFs a cost advantage over index mutual funds.
For example, ETFs don't redemption 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, ETFs pay with in-kind positions in other securities—a strategy that also avoids capital gains distributions for shareholders, but of course capital gains taxes are still owed on the sale of shares.
Another cost difference between ETFs and index mutual funds is that ETFs have less cash drag: 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.
Another important difference is that, although ETFs and mutual funds are both subject to tax on capital gains and dividend income, ETFs are more tax efficient than index funds because they are structured to have fewer taxable events. As mentioned previously in this article, an index mutual fund that must constantly rebalance to match the tracked index generates taxable capital gains for shareholders. The structure of an ETF minimizes taxes by trading baskets of assets, which protects the investor from exposure to capital gains on any individual security in the underlying structure. Of course, shareholders of both will owe capital gains taxes when selling their shares for a profit.
The relative benefits and drawbacks of ETFs vs. index mutual funds have been debated in the investment industry for decades, but—as always with investment products—the choice depends on the investor. Typically, the choice will come down to preferences on management fees, shareholder transaction costs, taxation, and other qualitative differences.
Most retail investors (non-professional, individual investors) prefer index mutual funds. Despite the lower expense ratios and tax advantages of ETFs, retail investors prefer index mutual funds for their simplicity and their shareholder services (like 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 grew significantly through the 2010s, 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 ease, speed, and flexibility of ETFs allow 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.
What Is the Biggest Difference Between ETFs and Index Mutual Funds?
The biggest difference is that ETFs can be bought and sold on the stock exchange (just like individual stocks)—and index mutual funds cannot.
Which Has Higher Returns: ETFs or Index Mutual Funds?
ETFs and index funds deliver similar returns over the long term. Of note, investment research firms report that few (if any) active funds perform better than passive funds like ETFs and index mutual funds.
What Triggers Taxable Events in Index Mutual Funds?
In nearly all cases, it is the need to sell securities that triggers taxable events in index mutual funds. The in-kind redemption feature of ETFs eliminates the need to sell securities, so fewer taxable events occur. Of course, investors in both will owe capital gains taxes when selling their shares in the fund.
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Now, let's dive into the concepts mentioned in the article "ETFs vs. Index Mutual Funds: An Overview."
Passive investing is an investment strategy that aims to match, rather than beat, the performance of a specific market index. It avoids the cost of active portfolio management and focuses on replicating the performance of the index. Passive investing has gained popularity due to its lower management fees and potentially higher returns on investment compared to active strategies [].
Exchange-Traded Funds (ETFs)
Exchange-Traded Funds (ETFs) are pooled investment vehicles that provide exposure to a diverse range of assets, such as stocks, bonds, or other securities. ETFs are designed to track the performance of a specific index, sector, or investment strategy. Unlike index mutual funds, ETFs can be bought and sold on a stock exchange throughout the trading day, similar to individual stocks. This flexibility and liquidity make ETFs attractive to a broad range of investors, including both active traders and passive investors [].
Index Mutual Funds
Index mutual funds are investment funds that aim to replicate the performance of a specific financial market index. These funds typically track the composition of the index and make adjustments only when the index itself changes. Unlike ETFs, index mutual funds can only be bought or sold once a day after the market closes. They are less flexible and have lower liquidity compared to ETFs. However, index mutual funds are popular among buy-and-hold investors due to their simplicity and accessibility [].
Key Differences Between ETFs and Index Mutual Funds
There are several key differences between ETFs and index mutual funds:
- Trading Flexibility: ETFs can be bought and sold on the stock exchange throughout the trading day, while index mutual funds can only be traded once a day after the market closes.
- Liquidity: ETFs offer higher liquidity compared to index mutual funds due to their ability to be traded like individual stocks.
- Cost Structure: ETFs generally have a cost advantage over index mutual funds. ETFs often have lower expense ratios and can avoid certain costs associated with index mutual funds, such as redemption fees and cash drag.
- Tax Efficiency: ETFs are structured to be more tax efficient than index mutual funds. ETFs can use in-kind redemptions and trading baskets of assets to minimize taxable events for shareholders [].
Returns of ETFs and Index Mutual Funds
Both ETFs and index mutual funds aim to replicate the performance of a specific index. Investment research firms report that few, if any, active funds perform better than passive funds like ETFs and index mutual funds over the long term. Therefore, the returns of ETFs and index mutual funds are generally similar [].
Taxable Events in Index Mutual Funds
In index mutual funds, taxable events are triggered when securities are sold. The constant rebalancing that occurs within index mutual funds can generate taxable capital gains for shareholders. On the other hand, ETFs can minimize taxable events by using in-kind redemptions and trading baskets of assets. However, shareholders of both ETFs and index mutual funds will owe capital gains taxes when selling their shares for a profit [].
In summary, ETFs and index mutual funds are popular forms of passive investing that aim to replicate the performance of a specific market index. ETFs offer more trading flexibility and liquidity compared to index mutual funds, while index mutual funds are often preferred by retail investors for their simplicity and accessibility. The choice between ETFs and index mutual funds depends on factors such as management fees, transaction costs, taxation, and individual preferences [].