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Index Funds vs. ETFs – Everything Investors Should Know

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Index Funds vs ETFs

Index funds are mutual funds that are passively managed and track an index. This can create some confusion as mutual funds are usually actively managed, while exchange traded funds (ETFs) are usually passively managed. This post should help you understand the distinction between index funds and ETFs.

Mutual funds (including index funds) and ETFs are both types of professionally managed funds that pool capital from multiple investors. The biggest difference is that while ETFs are listed and traded like shares, mutual funds are not.

Actively managed funds are managed by a fund manager who makes investment decisions on an ongoing basis in an attempt to outperform an index, or ‘the market’. By contrast, passively managed funds are designed to mirror an index so that the performance of the fund tracks the performance of the index as closely as possible. Passive investing is also known as indexing – in fact, the term indexing was coined first.

One could actually say that ETFs are index funds since they are funds that track an index. However, the term index fund is typically used to refer to passively managed mutual funds – and for the purposes of this post when we say index fund we are referring to index-tracking mutual funds.

The History of Index Funds

The first mutual funds were launched during the 1920s. It wasn’t until 1975 that the first index fund was launched – though this was still some 18 years before ETFs emerged.

The first index fund was launched by Jack Bogle who many regard as the father of passive investing. The fund which tracked the S&P 500 index was initially called the First Index Investment Trust. Its name was later changed to the Vanguard 500 Index Fund, and it still exists today, though it is closed to new investors.

Differences between Index Funds & ETFs

Index funds and ETFs perform the same function, and from the point of view of the fund manager, there is actually very little difference. However, from the point of view of investors, there are some differences due to their legal structure and the way they are traded. For a more comprehensive breakdown of the differences between mutual funds and ETFs, you can read our previous post on the topic.

The following are the notable differences between index funds and ETFs from an investor’s perspective.

Pricing

Index funds are priced once each day, and any transactions are based on the NAV (net asset value) of the fund at that time. When you invest in an index fund or redeem your units of an index fund, the transaction will be based on the exact value of the assets those units represent.

ETFs are listed on a stock exchange like other shares and trade throughout the day. When you buy an ETF, you pay the offer price and when you sell an ETF you receive the bid price. The offer price will typically be slightly higher than the NAV, while the bid price will typically be slightly lower than the NAV. The bid-offer spread is therefore an additional expense for ETF investors. The more liquid an ETF and its underlying securities are, the closer the fund will trade to its NAV, and the narrower the bid-offer spread will be.

Trading times

As mentioned, ETFs trade throughout the day, while index funds are only traded once per day, usually at the closing price. This means that only ETFs are suitable for active traders. In fact, anyone wanting to time their trade during the course of a day will need to trade ETFs.

You can also trade ETFs with a limit order, which means your trade will only be executed if it reaches the price you are happy to trade at.

Commissions

Because ETFs are traded on a stock exchange, a commission is payable to the stockbroker. This used to be a major issue, but commissions are now very low and only make a sizable difference if the value of the trade is quite low.

Some index funds do charge upfront commissions, but it’s also possible to find an index fund that doesn’t charge commission.

Distributions

ETFs usually distribute all dividends paid by the companies in the fund to investors. If you want to reinvest that money in the fund you will have to buy new shares, and you will have to pay another commission to do so.

Some index funds automatically reinvest dividends in the index stocks. This means distributions are reinvested on your behalf, commission-free. These funds are called accumulation funds, while distribution funds pay dividends on to investors.

Minimum trade size

The minimum trade size for ETFs is the value of one share. Mutual funds typically have a minimum amount that can be invested. This will depend on whether it’s a lump sum investment or a recurring debit order – but the minimum can be anywhere from $50 to $10,000. Having said that, for most indexes, you will probably find an index fund at the lower end of that scale.

You can also invest in an index fund using regularly scheduled direct debits. This is possible but slightly more complicated for ETF investors.

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Index Funds vs. ETFs - Everything Investors Should Know

Conclusion

For the most part index funds and ETFs serve the same purpose, though the slight differences mean there are some situations where one is more suitable than the other. ETFS are usually better suited to active investors and investors who want more control over execution. Mutual funds are well suited to longer-term investors and those that want to invest at regular intervals using a direct debit.

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Richard Bowman is a writer, analyst and investor based in Cape Town, South Africa. He has over 18 years’ experience in asset management, stockbroking, financial media and systematic trading. Richard combines fundamental, quantitative and technical analysis with a dash of common sense.

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