The difference between an exchange-traded fund (ETF) and an index mutual fund is not as cosmetic as it might seem. Although both asset classes have unique advantages, deciding on what’s best for you requires due diligence and an objective assessment of one’s goals.
An index mutual fund provides broad exposure to the financial markets by tracking or matching the components of a market index, such as the S&P 500 or Nasdaq Composite Index. As a type of mutual fund, index funds usually provide low operating expenses, low portfolio turnover, and adherence to specific standards spanning tax management and the handling of tracking errors.
ETFs are similar to index mutual funds in that they provide ownership of an underlying asset and divide ownership of those assets into shares. However, they differ from index mutual funds along four important pillars, which are discussed below.
Differentiating ETFs From Index Mutual Funds
In terms of differences, ETFs and index mutual funds typically differ in fees, minimum investment requirement, taxation and liquidity.
1. Fees and Expenses
When it comes to expenses, ETFs have a slight advantage. For example, the Vanguard S&P 500 ETF (VOO ) has an expense ratio of 0.04%. A comparable index mutual fund, the Vanguard 500 Investor Shares (VFINX), has an expense ratio that is more than three times as high.
ETF holders traditionally had to pay commission to their brokers each time they bought and sold an asset, thus negating some of the cost advantages associated with the asset class. To overcome this obstacle and attract more people to the market, several big-name brokers like Vanguard and Charles Schwab have announced commission-free ETF trading. This appears to be the wave of the future as competition intensifies.
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2. Minimum Investments
ETFs also have a slight advantage when it comes to minimum investments. Investors can access an ETF with as little as one share, with Charles Schwab offering an initial minimum of just $1. Mutual funds, on the other hand, usually require a minimum initial investment of between $500 and $3,000.
3. Taxes
When it comes to tax efficiency, ETFs and index mutual funds are virtually on equal footing, as both provide distinct advantages over actively managed funds. What’s more, tax payments are deferred as long as investors continue to hold the funds (in other words, capital gains taxes only apply once the funds are sold).
4. Liquidity
Although ETFs and index mutual funds are considered highly liquid, ETFs can be bought and sold any time during normal trading hours. Index mutual funds, on the other hand, are cleared after the market closes. Therefore, the transaction will be cleared hours after it was initially placed.
Trends in Index Mutual Funds and ETFs
Although ETFs have only been around since 1993, they have quickly emerged as one of the most popular investment vehicles on the market. Index mutual funds, which predate ETFs by several decades, have also enjoyed significant growth. By the end of 2017, index mutual funds and index ETFs together comprised 36% of total net assets in long-term funds, up from just 15% in 2007.
Below is a breakdown of index fund growth as a share of the overall fund market between 2007 and 2017. As you can see, index ETFs and index mutual funds have grown significantly.
In terms of actual numbers, 453 index mutual funds managed total net assets of $3.4 trillion in 2017. Index ETFs, on the other hand, managed total net assets of roughly $3.3 trillion.
On the ETF side, equity ETFs have grown particularly quickly over the past decade as more brokers and financial advisors integrate them into clients’ portfolios. Although bond ETFs are also growing, smaller bond funds have less-established secondary markets, which partially explains their small size relative to equity ETFs.
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Advantages and Disadvantages of ETFs
From the perspective of passive investors, below is a breakdown of the advantages and disadvantages of ETFs.
Advantages
- Diversification: One of the core benefits of ETF investing is diversification. One fund can give an investor exposure to a group of equities or a specific slice of a market or region.
- Lower fees: When compared with actively managed funds, ETFs have much lower expense ratios.
- Tax advantages: ETFs are among the most tax-efficient assets insofar as they are held by the investor. Capital gains taxes only apply once the investor sells the ETF.
- Trade like a stock: Like equities, ETFs can be purchased on margin, sold short, and traded in the futures and options market.
Disadvantages
- Hidden costs: ETFs have low expense ratios but carry other direct and indirect costs, such as commissions and management fees.
- Often limited to larger companies: Depending on where you are investing, some ETFs offer limited exposure to small- and mid-cap companies, leaving the investor overexposed to large-cap companies.
- Lower dividend payments: Investors can earn dividends by investing in dividend-paying ETFs, but the yield is typically lower than owning the stock outright.
Advantages and Disadvantages of Index Mutual Funds
Similar to the above section, the following provides an overview of the advantages and disadvantages of index mutual funds.
Advantages
- Diversification: Index mutual funds offer the same diversification benefits of ETFs.
- Lower fees: Although index mutual funds typically carry higher expense ratios than ETFs, they are much cheaper than actively managed funds.
- Low risk: Compared with other asset classes, index mutual funds offer steady growth in a low-risk environment. Additionally, index funds typically outperform most non-index funds that are designed to beat the market.
- Tax advantage: Like ETFs, index mutual funds have limited exposure to capital gains tax.
Disadvantages
- Lack of flexibility: Since index mutual funds are designed to perform in lockstep with an index, they enjoy less flexibility than other asset classes.
- Lack of big gains: If you invest in an index mutual fund, do not expect to outpace the market as they are not designed to do so. This makes big gains harder to come by.
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The Bottom Line
As the size and growth rates of these markets demonstrate, ETFs and index mutual funds both carry significant advantages for passive investors. Regardless of which asset class you prefer, it’s important to evaluate each fund individually to determine if it meets your criteria for cost, structure, past performance and tracking error.
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