ETFs vs. Index Mutual Funds: An Overview

Both exchange-traded funds (ETFs) and index mutual funds are popular forms of 澳洲幸运5官方开奖结果体彩网: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 澳洲幸运5官方开奖结果体彩网:S&P 500 Index.

澳洲幸运5官方开奖结果体彩网:Active investing strategies require expensive portfolio management teams that try to beat stock market returns and take advantage of short-term pric﷽e 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 hi𓂃gher returns on investment.

Index investing has been the most common form of 澳洲幸运5官方开奖结果体彩网:passive investing since 1976, when 澳洲幸运5官方开奖结果体彩网: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 澳洲幸运5官方开奖结果体彩网:ETFs and index mutual funds are 澳洲幸运5官方开奖结果体彩网: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, th🃏e 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 澳洲幸运5官方开奖结果体彩网:commodity or a diverse colle😼ction of securities, a specific investment st♒rategy, or even another fund.

An ETF 🦋offers investors major diversification by providing expos🔥ure to a wide range of assets.

Intraday Trading

Unlike index mutual funds, ETFs are 澳洲幸运5官方开奖结果体彩网:flexible investment vehicles that are highly liquid. They can be bought and sold on a stock exchange throughout the trading day, just like indivi🍬dual 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 澳洲幸运5官方开奖结果体彩网:hedge funds) as well as passive investors (like 澳洲幸运5官方开奖结果体彩网:institutional investors).

Derivatives

Another reason why ETFs attract passive and active investors is that certain ETFs include 澳洲幸运5官方开奖结果体彩网:derivatives—a financial instrument ♓whose price is derived from the price of an unไderlying 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 predeterm🎃ined price on a predetermined future dﷺate. 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 澳洲幸运5官方开奖结果体彩网: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, ꦜsuch as:

• The S&P 500 (the most popular in the U.S.)
• The FT Wilshire 5000 Index (the largest U.S. equities index)
• The 澳洲幸运5官方开奖结果体彩网:Bloomberg Aggregate Bond Index
• The 澳洲幸运5官方开奖结果体彩网:MSCI EAFE Index (European, Australasian, and Middle Eastern stocks)
• The 澳洲幸运5官方开奖结果体彩网:Nasdaq Composite Index
• The 澳洲幸运5官方开🧔奖结果体彩网: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 fun🌼d portfolio changes only if the DJIA changes its composition.

If an index mutual fund is following a 澳洲幸运5官方开奖结果体彩网: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 澳洲幸运5官方开奖结果体彩网:benchmark.

Potential for Strong Returns

Although they are less flexible than ETFs, index mutual funds c♏an deliver the same strong ret⛦urns 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 tꦉracking and trading give ETFs a cost and potential tax advantage over index mutual funds:

• For example, ETFs don't have the 澳洲幸运5官方开奖结果体彩网: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 澳洲幸运5官方开奖结果体彩网:explicit costs (e.g., commissions) and 澳洲幸运5官方开奖结果体彩网:implicit costs (trade fees). ETFs avoid these costs by using 澳洲幸运5官方开奖结果体彩网:in-kind redemptions rather than monetary payments for exited securities. This strategy can limit capital gains distributions for shareholders (but of course, 澳洲幸运5官方开奖结果体彩网:capital gains taxes may still be owed when investors themselves sell their shares).
• ETFs have less 澳洲幸运5官方开奖结果体彩网:cash drag than index mutual funds. A cash drag is a type of 澳洲幸运5官方开奖结果体彩网: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 澳洲幸运5官方开奖结果体彩网: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 product𒁃s—ꦐthe choice of one over the other depends on the investor.

Typically, it comes down to preferences related to managem♓ent fees, shareholder transaction costs, taxa𝕴tion, and other qualitative differences.

Despite the lower expense ratios and tax advantages of ETFs, many retail investors (non-professional, individual investors) prefer index mut♚ual 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 advis🃏ers has grown significantly, the primary drivers of demand have been institutional inve✅stors 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, transiti🎃on 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 t🐽wo 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.