Comparing Traditional Index Funds, Exchange-Traded Funds (ETFs), and Mutual Funds

For investors that have neither the time nor the expertise to research into individual companies and stocks (most of us), investment products such as mutual funds, ETFs, or traditional index funds offer an attractive option for diversifying your portfolio and managing risk.  These three key types of investment funds are similar in their approach of pursuing diversification through pooled assets, but differ in the way they are purchased or traded, expense ratios, and their management strategies.

Overview: Index funds are investment tools of pooled assets that seek to mimic a particular benchmark as closely as possible by purchasing all the equities or a representative sample of a particular index.  Traditional index funds are passively-managed meaning, unlike their mutual fund cousins, they do not rely on an active portfolio manager that would conduct market research and make choices to invest in particular companies’ equities.  An exchange-traded fund (ETF) is a hybrid investment product that has characteristics of both a mutual fund and a stock. ETFs, similar to mutual funds and traditional index funds, allow investors to diversify their investments by focusing on pooled assets rather than picking individual stocks, but they are considered more flexible as they are purchased and sold on the open stock exchange.  ETFs, mutual funds, and index funds often seek to track a particular index of stocks, commodities, fixed-income investments, or other assets. Investors can use these tools not only to purchase U.S. and international equities, but also other assets classes such as real estate, through Real Estate Investment Trusts (REITs), energy and commodities, and bonds and treasuries.

Comparing ETFs and Mutual Funds: The first major difference between ETFs and mutual funds lies in their investment strategies.  Most (but not all) ETFs are passively-managed, meaning they seek to track and match the performance a particular index, such as the S&P 500 for example, and will purchase all of the equities in that benchmark but will avoid case-by-case decisions on picking certain stocks over others.  While some mutual funds also track an index, they rely on an active portfolio manager to conduct research and forecasting and will make investment choices on particular stocks and other assets in an attempt to outperform the benchmark. The second key difference is that ETFs are traded on stock exchanges during normal trading hours, similar to stocks, whereas investors can only purchase or sell assets in a mutual fund daily at the end of the trading day.  Lastly, mutual funds generally have higher fees than both ETFs (and traditional index funds) since they rely on active managers that have to not only conduct research, but also trade more frequently to meet investor demand and to try to beat the market.

Comparing ETFs with Conventional Mutual and Index Funds: ETFs and index funds are very similar in the fact that they both normally pursue a passively managed strategy that tracks an index. Index funds and ETFs will purchase all the shares of a particular index in an attempt to match – but not outperform – the market gains (or losses) of the sector.  While some newer ETFs have active management strategies or pursue a hybrid approach with elements of both active and passive strategies, most ETFs are index-based and can therefore be considered a subset of overall index funds. The key difference between ETFs and traditional index funds is how the equities are purchased and how often they can be traded during the day.  ETFs are traded on an open stock exchange similar to stocks, and are able to sell throughout the day because they have entered into arrangements with third party brokers. With traditional index funds (and mutual funds) investors purchase their shares directly from the company managing the fund, and can only buy into or sell their assets once a day at the end of trading day based on the Net Asset Value (NAV) of the shares.  ETFs have lower initial minimum investment requirements since investors can purchase a single share of an ETF. Index funds and mutual funds often have a larger minimum initial investment often as much as $10,000.

Keeping track of the similarities and differences of ETFs, mutual funds, and traditional index funds can be difficult since their is significant overlap between the three and they are all essentially different methods of pursuing the same objective: investing in pooled assets to diversify your portfolio and lower risk.  The below chart should provide an easier comparison tool:


Traditional Index Funds ETFs Mutual Funds
Investment Strategy Passively-managed Most are passively-managed; some newer ETFs are actively-managed Actively-managed; portfolio managers pick stocks.
Structure Purchased and redeemed directly from the company managing the fund. ETF sponsors enter into contractual arrangements with 3rd party “Authorized Participants”, which are normally large brokers. Shares are purchased directly from company managing the fund.  
Trading Purchased/redeemed once daily at end of trading day based on NAV; may have minimum initial amount of $1K-$10K range; no stop, limit, or open orders.  No margin trading. Trade like an individual stock during trading hours, at market price; through stop, limit, and open orders, or on margin. Purchased or redeemed only once daily, at the end of trading day based on NAV. No stop, limit, or open orders.  No margin trading.
Fees Asset-weighted average of .24 % in 2016 according to Morningstar*; some fees as low as .04%. Asset-weighted average of .24 % in 2016 according to Morningstar*; some as low as .04%. Active funds had average expense ratios of .75 percent in 2016 according to Morningstar*
Price/Net Asset Value Price issued at 4PM each day Fluctuates throughout trading day like stocks. Price issued at 4PM each day.
Taxes*/ Capital Gains Generally more tax-efficient, as passive managers trade less frequently resulting in fewer capital gains distributions to investors. Generally more tax-efficient, as only Authorized Participants can purchase and redeem shares directly from ETF in large blocks, meaning fewer capital gains distributions to investors. Less tax efficient, as active mutual fund managers normally trade more frequently to keep up with demand and try to beat the market, resulting in more capital gains distributions.

Further research on fees can be found at the following Morningstar.–average-fund-fees-paid-by-investors-continued-to-decline-in-2016/

*This information is general in nature.  Please consult a tax adviser for questions regarding the tax implications of investments with respect to your unique situation.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: