Important points
- Index funds track an underlying index. Both exchange-traded funds (ETFs) and mutual funds can be index funds if your goal is to track the returns of a benchmark index.
- ETFs and mutual funds that track indexes typically have lower management fees than actively managed ETFs and mutual funds.
- The price of a mutual fund is determined once a day and all trades are executed at that price, whereas the price of an ETF fluctuates throughout the day as it is bought and sold through an exchange.
Currently, investors looking to take advantage of the performance of major stock indexes like the S&P 500 are presented with two main vehicles: exchange-traded funds (ETFs) and traditional mutual funds. A prime example of this choice is found in Vanguard's products.
“For example, the Vanguard 500 Index Fund is available in both ETF (ticker: VOO) and mutual fund (VFIAX) format,” said Rodney Komezis, global head of Vanguard's Equity Index Group. “Both offer exposure to the same index, have lower costs and operate under the same regulatory structure.”
VFIAX is a mutual fund that tracks the S&P 500 index with a minimum investment of $3,000. VOO, on the other hand, is an ETF that tracks the S&P 500 and was trading at about $454 per share as of early February. Both options promise an affordable, transparent, and easily accessible way to invest in the S&P 500.
“This is definitely semantics, but for novice investors, it's important to understand that both mutual funds and ETFs can track an underlying index,” says Caleb Paddock, a certified financial planner and founder of Ten Talents Financial Planning. I think it will be helpful.”
In other words, index funds can be both mutual funds and ETFs, but not all ETFs and mutual funds are index funds, and some are actively managed instead of tracking an index.
John Meyer, Chief Investment Officer of Global X ETFs, said: “Index funds are just one type of fund.” An ETF or mutual fund that attempts to track the returns of a benchmark index. ”
However, there are still quite a few fundamental differences between ETFs and index mutual funds that investors should be aware of. Understanding these differences is critical to making informed decisions about which investment vehicles are more suited to your personal financial goals and investment style.
According to experts, the most important factors to consider when deciding between ETFs and index mutual funds are:
Both ETFs and mutual funds can track an index, which is a collection of stocks (or other assets) selected based on a specific rules-based methodology. These indices are often intended to represent specific market segments or the market as a whole.
To track the performance of an index, ETFs and mutual funds can either fully replicate its constituents or sample the most important and representative portion.
Full replication involves buying exact proportions of all the stocks in the index, whereas sampling involves buying a subset of stocks that represent the broader characteristics of the index. Sampling is often used to avoid the inclusion of illiquid components that can be difficult or expensive to trade.
When investors purchase shares of an ETF or units of a mutual fund, they receive proportional exposure to the stocks in the underlying index. This means that investors can indirectly own a portion of each stock in the index, benefit from its returns, and share in the risks.
However, one important thing to be aware of is tracking error. This refers to the difference between the return of an ETF or mutual fund and the return of the index it aims to replicate.
Tracking error is a common phenomenon because ETFs and mutual funds typically lag indexes due to transaction costs, commissions, and other expenses. This affects the accuracy with which an ETF or mutual fund reflects the performance of an index over time.
The way ETFs and mutual funds trade, including those that track indexes, is a major difference between the two investment vehicles.
Mutual funds trade based on their net asset value (NAV), which is calculated once a day. NAV is determined by subtracting debt from the fund's total net assets and dividing by the number of outstanding units.
This means that all investors who buy or sell mutual funds on a given day receive the same price based on the NAV, which is set after the market closes. This daily pricing reflects the value of the mutual fund at the end of the trading day and ensures that all trades are executed at this single price.
On the other hand, ETFs operate differently. “Index mutual funds can only be bought and sold at the end of the trading day through a fund manager, whereas ETFs trade on exchanges and trade throughout the day like stocks,” Meyer says.
ETFs also have a NAV that is calculated in much the same way as mutual funds, but their trading involves a market price that may differ from NAV. This mismatch can create a situation where the ETF trades at a premium or discount to its NAV.
To manage this and ensure that the ETF's market price closely matches its NAV, the ETF sponsor and authorized participants engage in a process known as “creation and redemption.”
This mechanism allows adjustment of the supply of ETF shares in the market and facilitates arbitrage opportunities that help align the ETF's market price with its NAV.
Authorized participants (APs), typically large financial institutions, play a key role here. They can interact directly with ETF providers to create new shares or redeem shares in large blocks, usually in exchange for delivery of the underlying assets or cash.
This two-way process acts as a balancing force, reducing the potential for large premiums or discounts to NAV and ensuring that the ETF trades at a price that closely matches NAV.
“Investors who value the flexibility of trading in real-time with a variety of order types may prefer ETFs, while investors who prefer the simplicity of buying and selling stocks only at their daily closing price may prefer mutual funds. “Maybe,” Comgys said.
Index ETFs and index mutual funds both have the benefit of low fees. This is a direct result of the low turnover of the index benchmark and efficient management of the portfolio.
This efficiency comes from the fact that these funds are not actively managed. No manager is tasked with selecting and managing a portfolio of stocks based on their own research or strategy. Instead, both instruments aim to reproduce the performance of a benchmark index, and this can be done systematically and with minimal intervention.
Both index ETFs and mutual funds have expense ratios. The expense ratio is expressed as an annual percentage of the fund's average net assets. For example, VOO's expense ratio is 0.03%, while VFIAX's fee is 0.04%. For a $10,000 investment, these expense ratios equate to annual fees of $3 and $4, respectively.
However, the total cost of ownership is more than just the expense ratio. For ETFs, an additional consideration is the bid-ask spread, or the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask).
This spread can impact the cost of buying and selling ETF shares, especially for illiquid ETFs. You can minimize these costs by choosing ETFs that are highly liquid and have low bid/ask spreads, sometimes as low as 0.01%.
On the mutual fund side, some funds may charge a load, which is essentially a sales charge or commission. Although these fees are less common, they are still a factor to consider as they can significantly increase the cost of investing in mutual funds.
Additionally, some mutual funds may have minimum investment requirements, which may be a barrier for some investors. In contrast, ETFs have no such floor price. An investor can buy from his single share, making it more accessible, especially for brokerages that offer fractional trading.
“For example, Vanguard mutual funds typically have a minimum initial investment of $3,000, while Vanguard ETFs can be purchased for as little as one share,” Comegies says.
Finally, the most important advantage that ETFs have over mutual funds that include index variants is their tax efficiency. This efficiency primarily stems from the creation and redemption mechanisms inherent in ETFs.
“For example, although the future is not guaranteed, both Invesco QQQ Trust (QQQ) and Invesco Nasdaq 100 ETF (QQQM) have provided shareholders with capital gain distributions since their inception,” said QQQ strategist Paul Schroeder. I haven't paid.'' At Invesco. “A key driver of this efficiency is the portfolio management team’s experience and ability to leverage the ETF’s physical creation and redemption process.”
In the case of mutual funds, if an investor decides to sell units, the fund's portfolio manager may be required to sell its holdings in the fund in an amount commensurate with the redemption.
This sale of securities may result in capital gains that will be distributed to all of the Fund's investors and may result in potential tax liability, including those who do not sell their shares. .
ETFs use different investment methods to increase tax efficiency. ETF shares are bought and sold on exchanges like stocks, so trades occur directly between buyers and sellers. If he needs to sell a large amount of his ETF shares, an authorized participant can step in to facilitate the trade.
Therefore, APs can purchase ETF shares and redeem them with the ETF sponsor in exchange for the ETF's underlying assets. This process, known as “spot trading,” allows ETF shares to be exchanged for securities without selling the underlying shares. As a result, the imposition of capital gains tax, which is passed on to the investor, can be avoided.
