ETFs vs. Index Funds: What’s The Difference?

by on September 13, 2010 | Updated May 26, 2014

When categorizing various investment vehicles, most investors tend to think of mutual funds and exchange-traded funds (ETFs) as polar opposites. Mutual funds are associated with active management, with a team of analysts and managers seeking to generate alpha by identifying undervalued securities from a relevant universe of stocks and bonds. ETFs, on the other hand, connote a passive investment strategy, products that seek to replicate the performance of a certain benchmark instead of seeking to beat it. For those who believe that active management (or at least certain active managers) add value, mutual funds may be preferred. For those who believe that it is impossible to consistently outperform markets, the lower-expense beta offered by ETFs are more attractive [see Five Advantages of ETFs].

While these classifications of mutual funds and ETFs are generally true–most mutual funds are actively-managed, and more expensive than passively-indexed ETFs–they certainly aren’t hard and fast rules of investing. There are, of course, actively-managed ETFs that utilize quantitative analytical strategies and manager expertise to select individual holdings, much like most actively-managed mutual funds. And there are mutual funds that seek to passively replicate an index, exhibiting characteristics similar to traditional ETFs. In reality, the true division is not between ETFs and mutual funds, but between active and passive. ETFs and mutual funds fall into both sides of that division [see When Is An ETF Not An ETF?].

ETFs vs. Index Funds: Similarities and Differences

Index mutual funds and passive ETFs are similar in a number of key ways. Most significantly, both seek to replicate the performance of underlying index. Although ETFs receive the bulk of the credit for the surge in popularity of indexing as an investment strategy, index mutual funds started the movement long before the first ETFs came to market. The Vanguard 500 Index Fund (VFINX), launched in 1976, is designed to track the return of the S&P 500, making it similar to the three ETFs that also seek to replicate the S&P 500. The recently-launched Vanguard S&P 500 ETF (VOO) is actually a separate share class of the S&P 500 index mutual fund, which has total assets of more than $90 billion [Download 101 ETF Lessons Every Financial Advisor Should Learn].

Because they seek not to generate alpha but to capture beta, index mutual funds are also similar to most ETFs in that they offer potential tax advantages resulting from lower turnover of underlying holdings. It also allows index mutual funds to charge low expense ratios that most investors associate with ETFs. The general assumption is often that all mutual funds maintain expense ratios significantly higher than ETFs. While that’s generally true when comparing passive ETFs with actively-managed mutual funds–the industry average for mutual funds is somewhere in the neighborhood of 1.4%–it isn’t universally true. VFINX, for example, charges just 0.18%; while that’s more than three times the charge for VOO, it’s lower than most of the ETF universe. And it’s significantly lower than the expense ratios charged by some actively-managed ETFs; the STAR Global Buy-Write ETF (VEGA), for example, offers a net expense ratio of 2.01% [see Ten Most Expensive ETFs].

The biggest difference between these two products is the frequency with which they are priced and traded. Index mutual funds are, after all, mutual funds, and as such they are priced once a day after markets close. ETFs–including both active and passive ETFs–are priced throughout the day, and can be bought or sold whenever the markets are open. Index mutual funds are priced based on the NAV of the underlying securities, whereas the price of an ETF depends on supply and demand for the security. Although the arbitrage mechanisms in place prevent ETF prices from deviating too significantly from the NAV, it is not uncommon for these securities to trade at a slight premium or discount. So in exchange for the flexibility to trade throughout the day, investors who utilize ETFs may incur a bid-ask spread to establish or close out a position [see Five Ways To Slash Your ETF Expenses].

Which To Use?

While index mutual funds and ETFs are similar in many ways, there are still some definite advantages to utilizing ETFs. The ability to trade ETFs at any time throughout the day–instead of having to wait until markets close to redeem at NAV–can be very valuable, especially in volatile environments. And while index mutual funds feature significantly lower costs than their actively-managed counterparts. The comparison between the mutual fund and ETF share classes of the Vanguard 500 Fund illustrate this quite well; as mentioned previously, VFINX charges 0.18%, while VOO charges just five basis points [see Actionable ETF Trading Ideas].

The primary advantages of index mutual funds, including the security of being able to execute buy and sell orders at the NAV, can be significant. Countless ETF investors have put themselves in a hole by buying at a big premium or selling at a big discount. But for those who know what they’re doing, the uncertainty associated with trading ETFs can generally be mitigated.

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Disclosure: No positions at time of writing.