Index Funds vs ETFs

ETFs have been dubbed mutual funds 2.0: Learn about the advantages of each.

In many areas of the market, there are both ETFs and mutual funds tracking the exact same index. Choosing one over the other comes down to prioritizing what matters to you.

Let’s review the fundamental difference between the two structures.

Index funds (mutual funds) and ETFs are both designed to track the performance of financial indices like the FTSE 100, S&P 500 or the Barclays Aggregate. They do this by pooling money from multiple investors and investing it. They may invest directly in the securities held within the index, or they may buy a swap contract that delivers the return of that index. Either way, they are funds that track indices. (Note: Actively managed ETFs and mutual funds do exist, but are outside the scope of this article.)

The difference between mutual funds and ETFs is really simple to grasp, and is hinted at by the name: ETFs are “exchange traded.” That means you can buy and sell them intraday at the London Stock Exchange. By contrast, you can only buy or sell index funds once per day, after the close of trading. You do this by contacting the mutual fund company directly and telling them you want to acquire or redeem shares.

What does all that mean for investors? And how do you choose? Let’s examine the differences.

The Positives of ETFs

1) Intraday Liquidity: Those fancy words mean you can buy and sell ETFs at any time during the trading day. If the market is falling apart, you can get out at 10 am. In a mutual fund, you would have to wait until after the close of trading … which could be a costly delay.

2) Lower costs: Although it’s not guaranteed, ETFs often have lower total expense ratios than competing mutual funds. The reason is simple: When you buy shares of a mutual fund direct from the mutual fund company, that company must handle a great deal of paperwork to record who you are, where you live and to send you documents. When you buy shares of an ETF, you do so through your brokerage account, and all the record-keeping is done (and paid for) by your brokerage firm. Less paperwork equals lower costs. Most of the time.

3) Transparency: Holdings are disclosed on a regular, frequent basis so investors know what they are investing in and where their money is parked.

4) Tax Efficiency: Structurally, ETPs are almost always more tax-efficient than mutual funds because of the process for adjusting share supply and the method with which ETPs turn-over their portfolio.

5) Greater flexibility: Because ETFs are securities, you can do things with them you can’t do with mutual funds, including writing options against them, shorting them and buying them on margin.

6) Intraday Pricing:  ETF issuers publish NAV throughout the day which is a boon to investors who can see the value of their investment and use it as a benchmark for assessing current market prices.

The Cons Of ETFs

1) Commissions: The beauty of intraday liquidity does not come without costs: Typically, you pay a commission when you buy or sell any security, and ETFs are no different. If you regularly invest a small amount of money in a fund—say, 1,000 pounds per paycheck—these commissions can be cost-prohibitive.

2) Spreads: In addition to commissions, investors also pay the “spread” when buying or selling ETFs. The spread is the difference between the price you pay to acquire a security and the price at which you can sell it. The larger the spread—and for some ETFs, the spread can be quite large—the larger the cost.

3) Premiums and Discounts: When you buy or sell a mutual fund at the end of the day, you always transact exactly at NAV, so you always get a “fair” price. While mechanisms exist that keep ETF share prices in line with their fair value, those mechanisms are not perfect. At any given moment, an ETF might trade at a premium to its NAV or a discount. If you buy at a premium and sell at a discount, ouch … you’re in for some pain.

4) General Illiquidity: While exchange-trading sounds great, not all ETFs are as tradable as you might think. Some trade rarely, or only at wide spreads. These become the financial equivalent of the Hotel California: You can never leave. (Mechanisms exist that allow for NAV-based trading directly with the issuer in ETFs, but they are more involved than with funds.)

Conclusion

Neither mutual funds nor ETFs are perfect, but both offer solid exposure at minimal costs, and can be good tools for investors.

For most, the choice comes down to what you value most: If you value tax efficiency, the flexibility of intraday trading, and want to minimize holding expenses you may find ETFs are a better choice. If, instead, you worry about the impact of commissions, premiums, spreads and other factors, mutual funds may be a better choice.

Importantly, there is no reason this has to be an either/or question. Mutual funds can live side-by-side with ETFs in an account perfectly happily.