The differences between investment vehicles can be confusing for many investors. For example, exchange traded funds (ETFs) and index funds (a type of mutual fund) can be a source of confusion largely because many investors think these two vehicles essentially represent the same type of product.

The truth is, ETFs and index funds do have many similarities. However, there are differences between the two.

Mutual Funds and How They Relate to Index Funds

Broadly speaking, mutual funds are a basket of securities that are professionally managed by an investment company. In exchange for that management, investors pay a fee to an investment company based on the level of management involved.

Actively managed mutual funds usually cost more than passively managed funds. The aim of an actively managed mutual fund is to “beat” market returns. The aim of a passively managed mutual fund is to “match” market returns as measured by indexes.

Bearing those definitions of actively and passively managed mutual funds in mind, index funds are, typically, passively managed mutual funds.

Examples: Mutual Funds with Index Benchmarks vs. Index Funds Based on Indexes

There’s a difference between mutual funds with index benchmarks and index mutual funds. For example, an actively managed mutual fund with an S&P 500 Index benchmark would typically include stocks from that index that your investment company specifically selected based on anticipated outperformance. Investors pay for the increased research and investment expertise required to make these stock-selection decisions.

On the other hand, an index fund based on the S&P 500 Index simply seeks to replicate the index, with no estimates regarding anticipated performance. Such funds cost less to operate, so investors generally pay smaller fees, which is where the benefit lies. Passive investors believe that trying to beat the market is so inherently difficult that matching market returns and saving on fees will ultimately create better overall results.

Despite differing investment philosophies, these mutual funds share the same pricing structure. Shares in mutual funds are priced once a day based on the net asset value (NAV) of the fund. Investors who own these funds buy and sell based on that once-daily price. For example, if you sell an index fund after market close, your actual selling price will not be available until the following day when the mutual fund company sets its next NAV. Mutual funds may also have minimum holding periods.

Enter ETFs

An ETF is similar to an index fund, minus its pricing structure. When you buy an ETF, you usually get the same passive-investment structure and lower fees as an index fund; however, ETFs act more like individual stocks. They are sold through stock exchanges, like single stocks, so investors can buy and sell at any point in the day at the going market rate—and there are no minimum holding periods. This intraday liquidity is popular with many investors.

Caveat Emptor!

While any of these investment vehicles are relatively simple to understand, there are some cautions to consider before making an investment. Some of them include:

• Cash drag – Sometimes funds are not fully invested in the market. Instead, they have lots of cash, which is called cash drag. You should always determine the amount of cash a fund is holding, and generally, avoid buying a fund with too much cash drag.
• New product confusion – Largely due to the popularity of passive investing, index funds and ETFs have grown exponentially in popularity. This growth brings with it myriad new products. Some have a very narrow niche, which may not be appropriate for an investor who is seeking diversification. Be sure to fully understand the fund’s niche, based on its benchmark, before you invest.
• Similar product names – Most investors generally associate index funds or ETFs with passive management, but some companies now sell index funds or ETFs that are actively managed, with fees that are correspondingly higher. Be sure to fully understand the underlying investment philosophy, fees, expense ratios and any trading costs associated with an investment vehicle before you purchase it.

Our Take

The differences between ETFs and index funds can be nuanced and somewhat confusing if you’re new to the investment game. If you need help with some of the details, a skilled financial advisor can help you determine the most appropriate investment product depending on your unique circumstances and financial objectives.