Index funds have gained in popularity in recent years due to their relatively low cost compared to most actively managed funds. This is largely due to the fact that many index funds have outperformed a high percentage of their actively managed counterparts.
Given these and other attributes, you may be thinking that investing primarily via index funds is the way to go for your investment portfolio. You are now faced with the choice of how to go about this; either via an index mutual fund or an index ETF.
Index Funds
An index fund is a type of investment that aims to track the performance of a market index. A market index is a group of securities that hold similar characteristics.
There are hundreds of market indices, and each has the goal of tracking the performance of a sector, region, country, security type, or other characteristic. Index funds typically provide widespread exposure to different markets, sectors, or sub-sectors.
Index Mutual Funds vs ETFs
Both ETFs and mutual funds are pooled, professionally managed investment vehicles. Both index mutual funds and index ETFs are managed to closely track the performance of the underlying index of the fund.
ETFs are in many ways a form of mutual fund, but with some very distinct differences. For one fund family, Vanguard, their ETFs are actually considered to be another share class of their mutual funds. But even with the Vanguard index mutual funds and index ETFs there are some differences between mutual funds and ETFs:
- ETFs are traded like individual stocks and can be bought and sold during the normal stock market trading hours. For most folks this is not a big deal, but for those investors looking to buy or sell at a certain level this can be an advantage.
- Stop orders, limit orders and stop limit orders can be used with ETFs, but not with a mutual fund. These types of orders can be used limit your potential losses if the share price of the ETF falls to a specified level. This can be helpful under volatile stock market conditions such as those we are currently experiencing. This can also be used when you are looking to buy an ETF but don’t want to purchase the shares above a certain price level.
- For investors looking to buy on margin this is possible with an ETF but not with mutual funds. A margin account allows investors to borrow the funds from their broker to purchase ETFs or other allowable securities. Margin accounts can serve to magnify any gains, but also any losses you might incur.
- ETFs are much more transparent as to the underlying holdings in the fund, they are required to report their holdings each day. Mutual funds, on the other hand, have much less frequent reporting requirements. Conceivably this shouldn’t make a difference with an index fund, but with an ETF there is no guessing.
- Mutual funds are a solid alternative if you are looking to invest the same dollar amount into the fund on a regular basis, such as monthly. Since mutual funds can be purchased as a dollar amount versus the need to purchase a specific number of ETF shares, mutual funds are the better option here.
- Investors who wish to reinvest distributions from their holding are better served using an index mutual fund versus an ETF. This is easily done with a mutual fund while it often is not available with an ETF.
Costs And Expenses
This will of course depend upon which index mutual fund or ETF that you purchase, but generally both index mutual funds and ETFs have very low expense ratios. In general an index ETF will carry a lower expense ratio than a mutual fund tracking the same index, though not always.
Most, but not all index mutual funds may require a minimum investment, while you can often get started with index ETFs with as little as a single share. While buying or selling ETFs has typically involved paying a transaction cost, many brokers and custodians are waiving these transaction costs in response to the competition.
Not a cost per say, but some index mutual funds may require a minimum investment to invest in the fund. This varies widely among funds and fund families. For example, the popular Vanguard 500 Index Fund (ticker VFINX) carries a $3,000 minimum initial investment.
Tax-Efficiency
If you are investing inside of an IRA or some other type of tax-deferred (or tax-free in the case of a Roth IRA account) the tax-efficiency of the mutual fund or ETF doesn’t really matter. It does matter, however in a taxable account.
Index funds of both types are generally more tax-efficient than actively managed funds. This is because there are generally fewer transactions within these funds than in an actively managed vehicle.
That said, ETFs are generally more tax efficient than mutual funds, even in the case of index funds. Index mutual funds can be efficiently managed in terms of a relatively small number of transactions.
However, unlike ETFs, mutual funds need to have cash on hand to meet shareholder redemptions, especially during periods of market turmoil. This can lead to the fund manager needing to sell some of the underlying holdings in the index mutual fund in order to raise the cash needed for these redemptions. This can result in the mutual fund experiencing larger capital gains than it might normally, these gains are then passed through to the fund’s shareholders.
ETFs, on the other hand do not have the need to raise cash for redemptions. When an ETF shareholder needs to raise cash, they simply sell some or all of their shares at whatever the market price of the shares is at the time of the sale.
Which Is Better: Index Mutual Funds vs ETFs?
Like many things in the realm of financial planning and investing, the answer is that it depends on your particular situation.
For investors who are starting out and trying to build a portfolio, using index mutual funds as a portfolio building block makes a lot of sense. The ability to invest a set dollar amount monthly or periodically can offer a significant opportunity for investors in this situation.
For investors who are more experienced with portfolios that are larger and a bit more diversified, index ETFs can make a lot of sense. Investors holding index funds in a taxable account might be a bit better using index ETFs due to their tax advantages.
Frankly, both index ETFs and index mutual funds are generally solid investment options, and both can serve investors well.
Where To Buy Index Mutual Funds or ETFs
If you want to invest in index mutual funds, you can do this directly through the fund provider website or through a discount brokerage firm. Examples include Vanguard, Fidelity, and Charles Schwab.
If you are looking to purchase ETFs, you can do so through a few different avenues:
- A brokerage like M1 Finance allows you to invest in ETFs commission free with fractional shares.
- A robo-advisor like Betterment will invest your money into ETFs on your behalf based on your goals and risk tolerance.
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