A good way to understand these three investment vehicles is to think of an inverted pyramid. Mutual funds are at the top, the broadest category. Beneath them are index funds, which are a specific type of mutual fund. ETFs are at the bottom of the pyramid, as a subset of index funds.
A mutual fund is an actively managed fund designed to achieve specific investment goals. Fund managers have broad discretion to choose which securities to hold in the fund in order to meet its underlying objectives. For example, the Fidelity Telecom and Utility Fund (FIUIX) seeks to maximize returns by investing in utility companies with good income and capital appreciation. The fund manager seeks out equities that match the fund’s investment criteria and sells off those that fail to perform.
Of the three types of investment, mutual funds have the highest expense ratios, or percent of assets needed to cover the costs of managing the fund.
An index fund, on the other hand, is a passively managed investment. The fund is pegged to an index such as the Dow Jones or NASDAQ, and its basket of securities closely mimic those in the index. In other words, decisions about which equities the fund holds are outsourced to the people who develop the index.
Using the example above, if you wanted a less expensive way to invest in the utilities sector, you might choose the Vanguard Utilities Index Fund, which is pegged to the MSCI US IMI/Utilities Index (VUIAX). The utilities mutual fund has an expense ratio of 0.55%, or $5.50 for every $1,000 invested, while the index fund costs just 0.10%, or $1.00 per $1,000 invested.
When you buy and sell mutual funds and index funds, you do so through the company that sponsors it, either directly or indirectly through a brokerage account. Transactions are settled at the close of the market day based on the fund’s net asset value, or NAV. Mutual funds and index funds almost always require a minimum initial investment.
Exchange-traded funds, or ETFs, are most often pegged to a stock index, although they may also invest in commodities, currencies, or bonds. ETFs can be bought and sold throughout the day; unlike index and mutual funds, which are bought and sold through the fund company, ETFs are traded on the exchange, just like individual stocks. Your transaction is with another investor, not with the fund sponsor.
ETFs also tend to have lower expense ratios, generally in line with, or lower than, index funds. For example, Vanguard offers an ETF version of its Utilities Index Fund, the Vanguard Utilities ETF (VPU), which also has an expense ratio of 0.09%. Unlike index funds and mutual funds, however, there is no minimum investment for ETFs. You can buy and sell a single share, if you are so inclined.
If you’ve decided that index investing is the best way to achieve your financial objectives, it’s important to understand key cost differences between index funds and ETFs before you decide which type of fund to buy.
Index funds may have an advantage here, because many companies offer index funds with zero transaction costs, whether the funds are bought directly or through a brokerage intermediary. You’ll pay a transaction fee or commission every time you buy or sell an ETF, on the other hand.
When more money comes into an index fund than goes out through redemptions, the fund manager needs to buy more securities to keep the fund’s ratio of securities and cash or cash-equivalents in balance. When more money goes out than comes in, the manager needs to sell off securities to keep the cash ratio in balance.
There are direct costs involved in these transactions in the form of commissions, and indirect costs in the bid-ask spread of these trades. ETFs, on the other hand, have a unique creation/redemption process that avoids transaction costs. They can simply create more shares or redeem old ones to rebalance.
Rebalancing is also related to cash drag, which results from holding necessary cash reserves in an index fund to cover transaction costs and redemptions. ETFs typically don’t need to hold as much cash, thereby avoiding cash drag.
Every time a fund sells off securities, it risks triggering a negative tax event due to capital gains. Because index funds are constantly rebalancing, there is a higher risk of capital gains exposure than with ETFs, because ETFs use the creation/redemption in-kind process instead of selling portfolio assets.
Index funds have a clear advantage when it comes to dividends, because they are reinvested into the fund as soon as they are realized. ETFs, however, accumulate dividends until they are distributed to shareholders at the end of the quarter.
Which one should you choose? It depends. Index funds and most ETFs are pegged to stock indices, which makes it easy to get low-cost broad exposure to a specific market sector. Mutual funds, on the other hand, have more flexibility and versatility to invest in niche markets or other complex investments, but you’ll pay a higher price overall.