Last Updated on July 28, 2021 by pf team
ETFs and index funds can be similar in several ways — and can even be the same thing or serve a similar goal.
But there can be some meaningful differences as well and it pays to understand the pros and cons of each.
What are Exchange-Traded Funds (ETFs)?
An Exchange-Traded Fund (ETF) is a type of mutual fund that’s traded openly on stock market exchanges. Traditional mutual funds are bought and sold through brokers or directly through fund providers.
This structure can make a mutual fund investment less nimble than ETFs, particularly because traditional mutual fund trades don’t settle based on the price at the time of sale.
ETFs, however, trade differently, settling at the price of the trade when executed.
This, combined with some other features unique to ETFs, make exchange-traded funds easier to trade and providing liquidity without share-price surprises.
After some false starts and attempts with mixed results, the first successful US ETF was introduced in 1993.
This ETF was the S&P SPDR, with the latter part of the name short for Standard & Poor's Depositary Receipts and commonly just referred to as “spider”.
There are now 15 ETFs trading under the SPDR brand and the ETF market has grown exponentially with funds from a multitude of fund sponsors, providing investment choices ranging from broad index funds to specialized sector-specific funds.
ETF advantages and disadvantages
Much like mutual funds changed the market, ETFs represent a new investment path for investors and institutions as well as an efficient way to leverage short-term market movements.
The unique structure of ETFs bring both advantages and a few disadvantages when compared to other types of funds.
- Trade like stocks: ETFs trade on stock exchanges and can be easily bought or sold through most brokers.
- Predictable settlement price: You can use limit orders to choose your buy or sell price. Additionally, trades settle at the price of the buy or sell transaction, whereas mutual fund buy and sell prices funds may vary because trades settle at the end of the day.
- Built-in diversification: True is both index ETFs and index funds, your investment is diversified among a wide selection of companies.
- Dividend reinvestment: Dividends can be automatically reinvested.
- Lower expense ratio: ETFs often have a much lower expense ratio than both managed mutual funds and index funds.
- Tax-efficiency: ETF shares are created and redeemed in a way that avoids a capital gain for the ETF, thereby reducing the tax expense associated with the index ETF.
- Wide spreads in thinly traded ETFs: Smaller ETFs can experience the same challenges as a small stock, where infrequently traded equities can have a larger spread between the bid and ask price, often creating an invisible tax on earnings when it's time to trade.
- Potentially higher trading costs: If the ETF you choose isn't available as a commission-free ETF, trading costs can put a dent in your earnings.
- Muted dividend yields: when compared to choosing stocks individually or some managed mutual funds, dividend yields for ETFs can be lower.
- Higher risk when using leveraged ETFs: Some ETFs use leverage to increase potential earnings. The flip side to this strategy is that losses can be compounded as well during market downswings.
What are Index Funds?
ETFs and index funds aren’t mutually exclusive. ETFs can track an index, with some of the largest ETFs tracking the S&P 500. As a technical matter, ETFs can be index funds.
However, when people refer to index funds, they are typically referring to index mutual funds, like the Vanguard 500 Index Fund (VFINX), famous for being the first index fund available to investors.
Founded in the mid-1970s, the Vanguard 500 remains a popular choice for investors today, having returned 11.03% average annual return since inception.
A shorter duration measurement shows a 10-year annualized return of 14.54% compared the the S&P which returned 14.70% annually, demonstrating how closely the fund tracks the index.
S&P index funds are popular because they represent about 80% of the investable market through the equities held by the funds.
Funds tracking other indexes are available as well, like Dow funds that track the 30 stocks in the Dow Jones Industrial Average, giving a portfolio blue-chip quality and diversification without having to buy 30 different stocks in weighted investment amounts.
Of course, mutual funds can also serve a targeted investment goal with active management rebalancing the fund’s assets in accordance with the goal.
Interestingly, though, actively managed funds often underperform the broad market either due to the performance of individual assets held by the fund or because of the additional expense associated with more frequent trading.
Index Funds advantages and disadvantages
Choosing an index fund over an ETF or over direct investments can have its pros and cons. With an index mutual fund, you purchase shares in the fund while the fund itself owns the assets.
The value of the shares in the index fund are based on the value of the assets held by the fund. This structure is universal for traditional mutual funds.
However, you'll find that there are several types of structures for mutual funds in regard to fund expenses or trading costs.
Index Funds advantages
- Lower risk: Investing in specific stocks or even in specific sectors can be risky. Index funds reduce risk by providing a natural diversification, particularly with S&P index funds, which track 500 individual stocks within the index.
- Low fees: actively managed mutual funds tend to have much higher fees, including management fees, when compared to index funds. However, both index funds and ETFs are known for their low fee structure.
- Potentially lower trading costs: Depending on which index fund you choose, the cost of buying or selling shares can be lower — or in some cases, there may be no cost at all.
Index funds disadvantages
- Limited growth potential: Because an index fund tracks a broad market index, the upside potential is limited to that of the broad index. In reality, index funds tend to track slightly below their benchmark index due to trading costs or other expenses.
- Downside risk: If the broad market is in freefall, investment performance will take a hit due to falling market prices because index funds are not actively managed. The same is true of index ETFs. By comparison, actively managed funds may be able to mitigate short-term losses by choosing a more favorable short-term position or simply selling shares and holding cash instead.
- Fund-specific expenses: some index funds may have loads, which are front-end or back-end commissions paid on transactions, like buying shares or selling shares. Expense ratios vary by fund, paying for management or administration expenses, and some index funds may have 12b-1 fees, which are marketing and advertising fees.
- Settlement based on closing: Mutual fund share prices are based on the closing value of the fund at the end of the trading day. For long-term investments, this is generally a smaller concern. However, for short-term investments or if you need to sell quickly for whatever reason, intraday price movements can result in a settlement value lower than anticipated.
- Minimum investment requirements: It's common to find a minimum initial investment requirement or even a minimum balance requirement for index mutual funds.
Should I buy Index Funds or ETFs?
While both mutual funds and ETFs can service a nearly infinite number of investment goals, it’s interesting to compare the performance of index funds and ETFs squarely focused on the same goal to see which performs better over time.
Fortunately, Vanguard, a company well-known for low cost mutual funds, offers both an index ETF and an index mutual fund that track the S&P 500. This makes longer term comparisons relatively easy.
Less fortunately, one of the funds (Vanguard 500 Index Fund: VFINX) is closed to new investors. However, we can still compare the performance to see the effect of each fund structure.
Vanguard’s S&P index ETF is called VOO and can be purchased through most online brokers, possibly without a commission — although available commission-free ETFs vary by broker.
VOO (Vanguard S&P 500 ETF)
- Expense ratio: 0.03%
- Minimum investment: None
- Average 5-year annual return: 10.86%
- S&P (Benchmark) average 5-year annual return: 10.91%
- +/- Benchmark: -0.05%
Vanguard’s well-known S&P index fund, which pioneered index investing, is called VFINX and until recently could be purchased directly from Vanguard or through select brokerages.
Be aware that different commission structures may apply when purchasing mutual funds through a broker as opposed to directly from the mutual fund provider.
VFINX (Vanguard 500 Index Fund Investor Shares)
- Expense ratio: 0.14%
- Minimum investment: N/A (closed to new investors)
- Average 5-year annual return: 10.76%
- S&P (Benchmark) average 5-year annual return: 10.91%
- +/- Benchmark: -0.15%
To create opportunities for new investors, the minimum investment for a third Vanguard fund option was reduced to $3,000. Vanguard 500 Index Fund Admiral Shares (VFIAX) is another index fund that tracks S&P performance.
VFIAX (Vanguard 500 Index Fund Admiral Shares)
- Expense ratio: 0.04%
- Minimum investment: $3,000
- Average 5-year annual return: 10.87%
- S&P (Benchmark) average 5-year annual return: 10.91%
- +/- Benchmark: -0.04%
To extrapolate these numbers, we can look at how each look over longer time periods, assuming the same average return each has provided for the past 5 years.
|$ 16,744.58||$ 16,669.20||$ 16,752.14|
|$ 78,613||$ 77,207.40||$ 78,755.51|
|$ 618,009.24||$ 596,098.30||$ 620,243.04|
The power of compound interest over time is obvious in these examples, but you’ll also note a remarkable difference in the value of the investment depending on which fund you choose.
VFIAX, the index fund, is very close to VOO, the ETF, in regard to expense ratio and therefore close in regard to overall performance.
However, it’s important to know that these are all low-cost funds.
The typical passive index fund has an expense ratio closer to 0.2%, which is considerably higher than popular index ETFs like SPY (0.09%), IVV (0.04%), or VOO (0.03%).
An index fund with a 0.2% expense ratio reduces investment performance by the same amount, changing a 10.91% S&P return to 10.71%.
Using the same $10,000 from earlier examples, the investment performance over 40 years is $585,428.73, more than $30,000 less than you would earn with VOO, the index ETF.
Why are ETFs cheaper than Index Funds?
Fees are the largest reason why most etfs or less expensive then index funds. With index mutual funds, in particular, it's important to read the fine print.
Depending on the funds you choose, it's possible that there could be several additional expenses that could affect your long-term returns. Not all of these expenses appear in the expense ratio.
For example, some funds use a load charge, which is a commission paid to the broker at the time of purchase or when you sell your shares.
Consider a front-end load of 2% to 5%, which isn't uncommon. In this case, your $10,000 investment is instantly reduced to $9,500 with a 5% front end load.
If your index fund has a 0.2% expense ratio, a $10,000 investment is worth $29,000 less than in the last example where the full $10,000 could be put to work.
In an index ETF, the earnings advantage is nearly $60,000 higher than with a 5% front load index fund with an average expense ratio of 0.2% over 40 years.
Some funds also charge a 12b-1 fee, which pays for marketing and advertising for the fund.
You’ll find this cost included in the expense ratio, but be aware of the cost because it can be an ongoing drain on your portfolio value.
Are ETFs more tax-efficient than Index Funds?
In a standard taxable account, tax efficiency of the investment structure becomes an important consideration.
Mutual fund owners typically face more taxable events as funds reallocate assets or sell securities to accommodate shareholder redemptions.
ETFs typically have fewer asset changes and use a different method to accommodate investment inflows and outflows.
ETFs create or redeem “creation units” to meet rising or falling demand.
This process avoids many of the tax challenges often found with mutual funds by drastically reducing capital gains tax events. The biggest tax consideration, however, often relates to portfolio turnover.
When a mutual fund rebalances or changes investments, it can create a taxable event for the shareholder.
For actively managed funds, portfolio turnover can create a tax headwind strong enough to challenge earnings over time.
For index funds and index ETFs, expect far fewer portfolio changes because the tracking index doesn’t change the companies in the index as frequently.
ETF vs Index Fund: ETFs are more economical to own
While there are some index funds that are competitive with an ETF from an expense standpoint, in general, ETFs are more economical to own — and as you already know, an investment dollar saved can become 50 or even 100 dollars, given enough time.
Look for ETF with high daily volume to ensure liquidity and to reduce the risk of high spreads between the bid and ask prices.
Also, look for the opportunity to purchase ETFs commission free, which is available for a number of ETFs with various online brokers.
While commission-free ETF trades shouldn’t be your only consideration, the small costs of trading are also opportunity costs of lost gains that can be several times higher over time.