ETFs, Index Funds, Mutual Funds: Which One Fits Your Financial Goals?

Key takeaways

• ETFs offer diversification trade like a stock or bond and have relatively low fees.

• Index funds offer simplicity because you decide which index you want to track and subsequently buy shares.

• Mutual fund investing can include professional portfolio management, dividend reinvestment, convenience, and managed risk.

Some investors believe that investing in funds is less risky than investing in individual securities because funds provide diversification. Yet, there are a number of different approaches to fund investing to consider. These include exchange-traded funds (ETFs), mutual funds, and index funds. Each has advantages and disadvantages, so let’s take a look at ETFs vs index funds vs mutual funds to see their differences and similarities. 

What are exchange traded funds or EFTs?

ETFs are a hybrid of fund investing and individual trading. They can offer the flexibility you get trading individual stocks while providing the diversification that funds offer. As the term implies, ETFs trade on exchanges like individual stocks and bonds. ETFs track the performance of a group of companies (an index or a bucket of stocks) instead of relying on the performance of one company.  Shares of an exchange-traded fund can also be bought and sold during market hours, just like individual securities. Because they are traded  like common stock, they can also experience price fluctuations over the course of a trading session. 

Bought and sold like individual stocks, ETFs have ticker symbols and trading prices are easily tracked over the course of a day. This is important because, the price of an ETF can rise and fall from moment to moment. Similarly, the number of shares on the market of a given ETF will vary as shares are bought and sold throughout each day.

How ETFs are managed

The nature of ETFs also renders them capable of being managed actively or passively. SImilarly to mutual funds, an actively managed EFT is one that is controlled by a fund manager who seeks to guide the investment toward the best possible return based on research and investment strategies. 

The upsides of actively managed ETFs are the potential for higher returns, lower costs vs. similar funds, tax efficiencies, and flexibility. The downsides include higher costs when compared to passively managed funds and a daily disclosure requirement which enables others to get out in front of a fund manager and possibly impact potential gains.

Market volatility can also lead to an actively managed fund trading for less than the value of its individual assets (net asset value deviation). Meanwhile, a passively managed ETF simply tracks the performance of the securities to which it is tied. While the primary upside is less volatility, the downside is a fixed-gain potential, where an actively managed fund might deliver stronger performance.

How ETFs are priced, traded, and taxed

Because ETFs trade throughout the day like individual stocks, their pricing can fluctuate. The value of an ETF is driven by the value of the holdings comprising it. This can be both good and bad. You could experience significant gains in the price of the ETF’s shares if all of the holdings in the fund do well on a given day. Conversely, the price of the ETF’s shares could fall if the securities within the fund are losing value. The good news is that divergences tend to correct rather quickly. 

On the other hand, actively managed ETFs can experience more significant fluctuations based upon the successes or shortcomings of the fund manager. ETFs are usually bought and sold through brokers, like the individual stocks with which they share the market. This means that, for the most part, you’ll need a brokerage account to trade in ETFs. And again, ETFs are traded throughout the day at the current market price. Also, ETF transactions can be subject to brokerage commissions.  By and large, most ETFs are index funds, which means they trade less frequently and in so doing create few taxable capital gains. Because ETFs are bought and sold between traders, an account manager can avoid selling holdings to satisfy investor redemptions.

ETF minimum investments, management fees, and expenses

ETFs can sometimes have lower expenses than actively traded mutual funds and, to a degree, passively managed index funds. Expenses associated with ETFs are delineated in terms of their operating expense ratio (OER). This is the rate the fund charges to cover portfolio management, administrative costs, and other associated expenses. These vary from fund to fund, so it’s important to include this consideration in your comparison deliberations. 

You may also encounter trading costs with an exchange-traded fund. While less prevalent than in the past, thanks to online trading, it’s still a good idea to ask your broker about this so that you don’t get blindsided by high commissions. If you use a brokerage that does impose these fees, you’ll typically pay for each transaction. In other words, every trade will incur a fee. Moreover, commissions tend to be flat, so the size of the trade doesn’t matter, the cost will be the same. 

Another cost you will encounter with an ETF is the bid/ask spread. This is the difference between the prices at which the fund can be bought and sold. Built into the market price, the bid-ask spread is often overlooked. 

ETF pros and cons

There are several potential benefits to exchange-traded funds. However, there are some issues to consider as well. 

On the positive side, ETFs provide diversification, they trade like a stock or bond, and they have relatively low fees. You can reinvest dividends immediately, you’ll experience limited capital gains taxes, and the price tends to be relatively free of premiums or discounts.

On the negative side, you might see less diversification than is possible with other types of funds. If you’re a long-term investor, the benefits of intraday pricing changes could be lost to you.  ETF dividend yields tend to be lower than those of individual stocks.

What are index funds?

Index funds trace the benchmark of a specific index such as the NASDAQ 100 or the S&P 500. For example, the NASDAQ 100 tracks the performance of the 100 largest non-financial companies whose securities are listed on the NASDAQ stock exchange. Buying into a NASDAQ 100 index fund, or an index fund for that matter eliminates the need to purchase stock in each of the companies included within the index This automatically diversifies your investment because your capital is spread over a broader swath of the marketplace than it would be with an investment in an individual security. The goal of an index fund is to duplicate the performance of the securities included in the index the fund tracks. Because index funds are tied to a set group of securities, they are considered passive investments.  You buy into an index fund and it delivers returns or losses based upon the performance of the companies included in the index.

Index fund pros and cons

Index funds have their upsides and downsides, like every other investment vehicle. 

On the plus side of the ledger, index funds are simple. You decide which index you want to track, subsequently buy shares, and go on with the rest of your life. Because such funds are passively managed, you will probably encounter lower management fees. Moreover, risk is potentially minimized because of the index’s inherent diversification.

On the minus side, other than deciding on the fund with which to go, you have very little other say in terms of the way the investment is managed. You’re riding with whatever holdings the fund houses, there’s no way around it. In other words, flexibility is rather limited. Another potential minus is the fact that while index funds routinely keep pace with the market, they rarely beat it.

What are mutual funds?

Mutual funds work like the other funds listed here, with a couple of significant differences. As the term “mutual” implicates, your investment capital is pooled with that of others to create a portfolio you might have difficulty assembling alone. Unlike index funds, mutual funds are actively managed. A  person is responsible for directing the trades that comprise the fund’s portfolio. Stocks can be added and removed from a mutual fund as the manager adjusts the fund’s performance strategy. Where an index fund is tied to a set group of stocks, mutual funds can be invested in whatever securities the fund manager might choose. They usually do this by trying to beat the performance of an established benchmark, such as the S&P 500 or the NASDAQ 100. Mutual funds are priced once a day after the market closes.

Professional money managers decide which securities to buy and sell; they handle mutual funds for a group of investors that pools their money. As a participant in a mutual fund, you’re entitled to a share of the income the investments produce, Naturally, you also share any losses that might be incurred. Nonetheless, mutual funds provide access to a broad variety of asset classes, both domestic and international. 

How mutual funds are priced, traded, and taxed

Mutual funds are actively managed in most cases. The goal, of course, is to maximize the return by outperforming benchmarks such as the S&P 500, NASDAQ 100, and other market indices. However, there are also passively managed mutual funds that do track indices such as those listed above.

Here, it’s useful to note that a mutual fund can be an index fund, but an index fund is not necessarily a mutual fund. A simple way to determine the price of a mutual fund is to calculate its Net Asset Value (NAV) at the end of a trading day. This is the overall value of a fund, less its outstanding liabilities. Because a mutual fund is typically composed of a number of different securities, the NAV is calculated on a daily basis, depending upon how the assets held within the fund performed that day. Because the price of any given asset can change from moment to moment, mutual fund valuations happen at the close of trading and apply to the following day of trading. This means you can’t really know for certain what the price will be when the trade is executed.

Generally speaking, when you buy into a mutual fund, your transaction is direct with the fund. This means you’re transacting on the primary market, as opposed to the secondary market, as with ETFs and the stock market in general.

Trades are executed the day following an offer at the NAV established at 6pm in the Eastern Time zone.

The nature of the tax liability of a given mutual fund depends upon the types of investments it makes and whether those assets generate short- or long-term capital gains. 

Short-term gains are considered ordinary income by the IRS and are taxed as such. Long-term earnings are considered capital gains and are taxed differently. The determining factor in this regard is the amount of time the investment generating the income has been part of the fund’s portfolio. 

Distributions you get from a security held for six months or less are considered short-term, while profits from an asset that has been in the portfolio for several years are looked upon as capital gains. And yes, this can be just as complicated as it sounds. It’s worthwhile consulting a tax attorney or a CPA familiar with the concept to avoid errors.

Mutual fund minimum investment, fees, and expenses

A number of mutual funds tout the fact that no minimum investment is required to participate. However, most retail mutual funds require an investment of between $500 and $5,000 to buy in. Some institutional class funds and hedge funds can demand $1 million or more.

The costs associated with investing in mutual funds can be summed up in three categories. These are the operating expense ratio (OER), load, and transaction fees:

• An OER covers the cost of operating the fund. These are typically deducted from the total return you get from the fund each year.
• The one-time commission assessed when shares are bought and sold is referred to as the fund’s “load.”
• Transaction fees are imposed whenever you make trades. Some brokerages have them while others don’t.

Mutual fund pros and cons

The benefits of mutual fund investing can include professional portfolio management, dividend reinvestment, convenience, managed risk, and fair pricing.

On the other side of the mutual fund ledger are potentially high expense ratios, sales charges, the potential for management abuses and malfeasance, tax liability, and unpredictable trade execution. 

Top Line about ETFs vs Index Funds vs Mutual Funds

ETF low expense ratios and few broker commissions are among the top reasons to consider exchange-traded funds. You have more flexibility, can invest in a wide range of asset classes and can purchase them at any time at the going price.

Index funds have lower fees, follow a passive investment strategy and seek to track the performance of the market under the premise that the overall market will usually outperform a single investment. 

Mutual funds offer advanced portfolio management, dividend reinvestment, risk management, convenience, and fair pricing. However, you must also be cognizant of high fees, tax inefficiency, unpredictable trade execution, and the potential for shady dealings by fund managers. 

One thing that ETFs, mutual funds, and index funds offer is diversification, which some people consider a good thing when it comes to investing. The key difference is that the vehicles you choose to accomplish this will vary depending upon your specific goals, circumstances, and tolerance for risk. 

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