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What’s the difference between an ETF and a mutual fund or an index fund?


Jane Goodwin
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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.

Transaction costs

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.

Rebalancing

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.

Tax issues

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.

Dividend policy

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.
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It’s easy to confuse ETFs with mutual and index funds because of the mix of assets in their structures. However, they have key distinctions.  

First off, a mutual fund includes various assets like bonds and stocks under the management of a financial company for a fee. Through a technique called active management, the custodian picks the most promising stocks using analytical research, personal judgment, and forecasts.

When it comes to index funds, the portfolio manager chooses all the shares in a category as opposed to the ones expected to do well. In contrast, ETFs are posted on an exchange instead of being sold by fund agencies. A brokerage account is necessary to trade the shares. Like stocks, you’re subject to brokerage fees per transaction. Think of ETFs as an index fund subgroup and index funds a subgroup of mutual funds.

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Hi Jane,

Picking the right asset can be daunting, especially if your options have similarities. That’s why investors have trouble separating mutual funds from ETFs and index funds. Mutual funds, for starters, feature different assets in one package. Suppose you want 100 distinct stocks. In a normal scenario, you would not only transact but also incur trading fees 100 times. For mutual funds, however, you only need one purchase.
Another distinguishing quality is the presence of managers. Though your portfolio is run by experts, a fee is deducted for the service. Conversely, index funds monitor stock market performance. They follow the stock values of companies with common attributes. Unlike mutual funds, they’re administered passively making them cheaper. Additionally, investment decisions rely on index rules. Index funds, therefore, are a class of mutual funds.
The fact that they incorporate several investments makes ETFs related to mutual funds. Even so, they operate in the stock market like conventional stocks. Similarly, they offer high liquidity because of their daytime trade. This is not the case for mutual funds that are valued and offloaded once when the trading day ends. 
 

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Hi Jane, thanks for asking the question.

An Exchange-Traded Fund (ETF) could be compared to a mutual fund in terms of that it resembles a basket of different stocks and assets, which together create a single investment product. ETFs are constructed by major financial management organizations, mainly due to the Securities and Exchange Commission regulations and because only major institutions have enough resources to create an ETF. 

However, an ETF comes with more benefits than a typical mutual fund, in terms of costs and taxes as well. The process of putting together and redeeming an ETF is quite different than mutual funds. Buying mutual fund shares involves paying cash to the fund, which is then used to buy securities and create new shares. If the investor decides to redeem their mutual fund shares, the fund takes the shares back and offers cash in return. When it comes to ETFs, creating it doesn’t involve cash. 

When it comes to index funds, the biggest distinction is that ETFs can be traded during the day like stocks, while index funds can be traded only for the price that was set at the end of regular trading hours. 

If you’re looking to make long-term investments, this shouldn’t be a major problem for you. Trading at different times during the day will not greatly influence the value of the investment in 10 years. However, when it comes to intraday trading, you should go with the ETFs because they can be bought and sold like stocks. Still, this doesn’t mean that index funds are a wrong choice for long-term investments, don’t get me wrong.

Even though they’re traded like stocks, trading ETFs is safer than trading stocks of individual companies, in terms of risk.
 

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