Index investing came into vogue after Jack Bogle launched the first index fund, the Vanguard 500 Index Fund (ticker: VFINX), in 1976. But while mutual funds pioneered index investing, they're facing steep competition from exchange-traded funds.
"Index ETFs are outpacing them in both flows and popularity," says Jeff Smith, managing partner at San Francisco-based FundX. By the time VFINX turned 35, there were 290 index mutual funds in the U.S. but 990 passive, U.S.-based ETFs, according to Morningstar.
The rise of index ETFs is unsurprising: "Due to their structure, ETFs have certain advantages over mutual funds, especially for taxable accounts," Smith says.
But index mutual funds aren't without their merits, too. Knowing whether an ETF or index fund is right for you can't be boiled down to a single blanket statement.
ETF vs. Index Fund: What's the Difference?
An index fund is a mutual fund that aims to track an index, like the S&P 500 or Dow Jones Industrial Average. As an index fund investor, you are along for the index's ride. When it's up, your fund is up; when it's down, your fund is down.
An index ETF also strives to mirror the performance of its benchmark index. Like index mutual funds, ETF index funds are passively managed so investors participate in all the movements of the underlying index.
While both index funds and index ETFs have the same investment objective, they take different approaches to achieving that objective.
The key differences between index ETFs and index funds are:
-- ETFs trade throughout the day while index funds trade once at market close.
-- ETFs are often cheaper than index funds if bought commission-free.
-- Index funds often have higher minimum investments than ETFs.
-- ETFs are more tax-efficient than mutual funds.
[See: 8 Investing Do's and Don'ts During Market Volatility.]
Trading Advantages of ETFs vs. Index Funds
The biggest difference between index ETFs and index funds is how they trade. "As their name implies, ETFs trade on an exchange like individual stocks, while mutual funds do not," says Dave Mazza, managing director and head of product at Direxion in New York.
You buy and sell mutual fund shares directly through the fund manager at market close when the manager calculates the fund's net asset value (NAV), the total value of the fund's assets less its liabilities divided by the number of shares outstanding.
Since the manager does his math only after market close, you never know the exact share price you'll receive. To compensate for this, index funds let investors buy in fixed dollar amounts as well as share amounts. Instead of buying five shares, you could buy $100 worth of the fund, which helps keep every penny invested.
"While trading on an exchange introduces flexibility, it does add a level of complexity into buying or selling in a brokerage account," Mazza says.
With ETFs, you can only buy or sell on a per-share basis. But since they are trading constantly throughout the day, you can have a pretty good estimate of the price. You can also use limit orders or stop orders to set a price threshold that you're willing to accept or pay.
This constant trading makes ETFs more liquid, or easier to get in and out of, than index funds since you don't have to wait until market close for you trade to go through.
There is a big caveat here: While frequently traded ETFs are more liquid than index funds, less widely traded ETFs can be much less liquid. Since index funds trade directly through the fund manager, you're essentially guaranteed there will be a buyer for your shares, even if you don't know the exact price you'll get.
With an ETF, you're relying on there being another investor to play counter-party to your trade. If no one is willing to buy the shares you're selling, you're out of luck. This is why it's important to pay attention to the trading volume of any ETF you purchase. Low trading volume can foreshadow a sticky situation.
Since an ETF's price is based on investor supply and demand, it may equal its NAV. An in-demand fund may get bid up, causing it to trade at a premium to its NAV while an out of favor ETF may trade at a discount.
A mutual fund, on the other hand, will always trade at NAV.
[See: 8 Tips for Choosing an Active Fund Manager]
ETFs vs. Index Funds: Which is cheaper?
Cheapness comes down to two factors when investing in funds: the price you pay to buy the fund through a trading commission or sales load, and the price you pay to own the fund through the expense ratio.
"With the elimination of brokerage fees for ETF trading, many mutual funds are at a disadvantage: they either pay fees to be on no transaction fee (NTF) platforms or they require the purchaser to pay a transaction fee," Smith says.
And mutual funds face another disadvantage as they "have higher administrative and operating costs than ETFs," says Taylor Jessee, a certified financial planner, certified public accountant and director of financial planning at Taylor Hoffman Wealth Management in Richmond, Virginia. "These higher costs are passed along to investors" through the expense ratio.
"Index ETFs typically have rock-bottom expenses, oftentimes below 0.05% or close to zero, whereas a comparable mutual fund version may cost more," Jessee says.
The other expense to watch out for is a sales load. A sales load is an additional charge, like a commission, mutual funds may charge investors. It's used to compensate the institution or firm issuing the fund.
Sales loads can be charged on the front-end when you buy the mutual fund or the back-end when you sell. While uncommon on index funds, mutual fund investors should always look for no-load index funds.
The last price hurdle index investors may face are investment minimums. Index funds may have minimum initial investments of upwards of $2,000. The only minimum on an ETF is its share price.
The Tax Advantages of ETFs vs. Index Funds
Where ETFs shine over mutual funds is in their comparative tax efficiency. Since mutual funds trade directly through the fund manager, the manager may need to sell shares of the fund's investments to generate cash needed to cover redemptions. This causes mutual funds to buy and sell within the fund more frequently than ETFs. And every time the trades generate net capital gains within the fund, it creates a taxable event for investors.
"Mutual funds are legally required to pay out capital gains to their shareholders each year," Jessee says. Even if you don't sell your shares, you may get a tax bill for gains incurred within the fund. This could happen even in a fund that's losing value.
ETFs do not have this distribution requirement. Instead, ETF investors are taxed on any capital gains only when they sell their shares.
That said, "index mutual funds tend to be highly tax efficient, so this may be a modest advantage for ETFs," Mazza says.
Of course, "if this is going to be bought in a tax exempt account, then there's really no difference" tax-wise, says Brian Sterz, portfolio manager of LA-based Miracle Mile Advisors. He tells investors to consider asset location when comparing the merits of ETFs versus index funds.
[See: 7 Tips to Trim Your Capital Gains Tax Bite.]
ETF vs. Index Fund: Which to Use?
"Generally speaking if you only have a little money to invest or are investing in a taxable account and concerned about minimizing taxes, then the ETF may be the better option," Jessee says.
ETFs are particularly advantageous if you're using a broker that doesn't charge a trading commission, which would generally make the ETF cheaper than its index fund counterpart.
"If you just want to put your savings plan on autopilot, then finding a cheap index mutual fund may work better, because most mutual funds ... let you automatically invest a certain dollar amount at set intervals," he says. ETFs can't be automated so you'd have to manually place each trade.
Be sure to examine the index underlying your fund, Smith says. "For example, not all large-cap growth indexes track the same stocks."
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