Exchange-Traded Funds (ETFs) vs. Index Funds; Weighing Differences, Pros and Cons

Capison Pang

Passive investment funds do not attempt to beat the market or provide the same level of professional guidance as actively managed funds.

Yet, today, nine out of the 10 largest mutual funds, based on assets under management (AUM), are passive. Why?

Pioneered by index funds in the 1970s, the idea behind passive investing was simple: very few actively managed funds consistently beat the market. A recent study, researching 2010 to 2020, found that only 24% of active funds outperformed the market over the past 10 years.

Add on the relatively high fees charged by active funds, and investors are often better off tracking various financial market segments and achieving market-average returns. Today, there are two main types of passive investment funds.

Since being introduced in the 1990s, exchange-traded funds (ETFs) have joined index funds as the dominant forces in passive investing. To many individuals, the nuances of ETFs and index funds are nearly indiscernible.

Both types of investment vehicles are considered subcategories of mutual funds and share many of the same characteristics. However, investing in one or the other can yield vastly different results depending on the individual.

Exchange-Traded Funds (ETFs) vs. Index Funds: Both Feature Diverse Holdings

ETFs and index funds are portfolios of collectively held securities. The underlying portfolios can range from a few dozen to a few thousand securities.

Portfolio diversification allows individuals to hedge their investments against downward swings. By bundling securities together, ETFs and index funds provide investors greater access to the financial markets while reducing risk and volatility. An industrial stock can drop 15% overnight, while the sector as a whole barely drops 3%, if it at all.

Exchange-Traded Funds (ETFs) vs. Index Funds: ETFs Have Become Popular

Introduced in 1993 as a subset of index funds, exchange-traded funds have become an increasingly popular option for investors looking to diversify their portfolios quickly and efficiently. Compared to other investment funds, ETFs’ liquid and cost-effective nature provide an enticing opportunity for many individuals. Today, there is approximately $7.74 trillion held across 7,602 different ETFs globally.

Exchange-traded funds are created from borrowed securities, likely from a pension fund, placed in a trust. The securities are then used to form creation units between 10,000 to 600,000 securities. The underlying trust has little movement beyond administrative oversight and dividend payments to the various ETF shareholders. ETFs are constructed from tiny slivers of the different creation units. Finally, shares of the ETFs provided by the trust are then sold on the open market, similar to stock issued by a company.

Since the underlying securities of an ETF are held in trust, owning an ETF share does not correlate to the direct ownership of securities. Unless an individual amasses the thousands of ETF shares needed to match and cash out a creation unit for its underlying securities — usually only possible for institutional investors — an investor cannot redeem ETF shares for underlying securities. Instead, an ETF share serves as a legal claim on the securities held in trust.

Exchange-Traded Funds (ETFs) vs. Index Funds: ETFs Offer Real-Time Pricing

The shares of an ETF are liquid enough for intraday trading on exchanges or over-the-counter (OTC), something not available for most other investment fund shares. Intraday trading also allows for ETF shares to be shorted or purchased on margin. Any price misalignments between an ETF and its portfolio are quickly captured by arbitrage traders, which move the ETF share price back into sync with its underlying securities.

Traditionally, ETFs were designed to be passive investments. However, since being introduced in 2008, active ETFs have experienced a significant rise in popularity. The difference between the two lies in how the underlying securities are managed and the resulting expense ratio.

Passive ETFs are designed to track an index or a popular benchmark, such as the S&P 500, Dow Jones Industrial Average or a specific industry or sector. ETFs of this type do not seek to outperform the market or its benchmark and are great for individuals looking to invest in a particular industry, sector or index. The ETF automatically adds or drops securities from its portfolio to match the index or benchmark they are assigned to emulate. As a result, passive ETFs do not offer the same professional guidance or support as other funds but charge lower fees. The average passive ETF expense ratio is 0.13%, meaning that for every $100 under management, 13 cents is paid to the fund manager.

Exchange-Traded Funds (ETFs) vs. Index Funds: Active ETFs Differ from Index ETFs

On the other hand, active ETFs attempt to beat the market through a team of analysts who continuously monitor the markets to select securities for the portfolio. ETFs of this type will typically have a particular index or benchmark they will track loosely. However, the fund manager will have the authority to deviate from the index or benchmark. An active ETF provides consistent professional oversight and securities analysis but also charges higher fees than passive ETFs. The average expense ratio of an active ETF stands at 0.66%. Outside of the fees and securities selection process, active and passive ETFs’ underlying structure and characteristics remain the same.

Most exchange-traded funds set investment parameters beyond just the industry or sector they follow. The three most common parameters are asset class (equity, bond, commodity, currency, etc.), style (value, growth and blend) and company size (mega-cap, large-cap, mid-cap, small-cap, etc.). These three classifications allow investors to better sort various ETFs by different risk profiles and potential return rates. Learn more about the various asset classes, styles and market cap classifications here.

Of course, there are drawbacks to every financial instrument. Intraday trading can be a double-edged sword for investors as short-term speculation on ETF shares can raise commissions and trading costs. Leveraged ETFs, which use debt to multiply returns, can also bring about losses several times the initial investment. Learn more about leveraged ETFs here.

One of the more common issues in ETFs for investors is the inconsistencies they bring regarding diversification. Many ETFs track indexes or benchmarks with narrow specifications, such as large-cap communications stocks, reducing portfolio diversification and increasing risk.

Like any investment fund, an individual needs to understand the parameters of a potential ETF investment. How narrow are its investment parameters? Is it leveraged?

Exchange-Traded Funds (ETFs) vs. Index Funds: How ETFs Produce Returns

In the end, what matters most for investors is how they can earn returns. There are three primary ways retail ETF investors can earn a profit: dividend payments, capital gains and an increased market value.

  1. Dividend payments arise from the income generated by interest and dividend payments from the various bonds or stocks held in the ETF portfolio. ETFs hold onto all dividends received from their underlying securities before paying them in full at the end of each quarter on a pro-rata basis.
  2. If the ETF sells an underlying security at a profit, the fund achieves a capital gain. At the end of the year, the ETF will distribute all capital gains it has collected minus any capital losses to investors.
  3. Investors can sell their ETF shares at a profit during intraday trading if the underlying securities in the trust increase in market value.

In short, exchange-traded funds are great investments for individuals looking for a cheap and efficient way to diversify their portfolios quickly. ETFs are backed by an underlying set of securities held in a trust and can be actively or passively managed. Passive ETFs look to capture a particular index or benchmark as closely as possible and do not seek to outperform the market.

Active ETFs treat their index or benchmark as a rough guideline and look to beat the market by selectively choosing and picking securities. Unlike most other investment funds, ETFs are liquid enough to be traded intraday on exchanges or OTC, allowing shares to be shorted or bought on margin.

For a more comprehensive overview of ETFs, click here.

Exchange-Traded Funds (ETFs) vs. Index Funds: The Rise of Index Funds

The first index fund, the Vanguard 500 Index Fund, was created in 1975. Initially characterized as “un-American,” experts were skeptical about investors’ willingness to buy a product uninterested in beating the market.

It took less than 25 years for the Vanguard 500 Index Fund to surpass the Magellan Fund, the largest actively managed mutual fund at the time. By 1999, it had raised more than $100 billion.

Index funds have since smashed the $10 trillion mark in total global AUM.

Despite acting as its own independent entity, most index funds are part of a much larger company that owns and operates dozens, if not hundreds, of various investment funds and vehicles. Some of the most common companies are The Vanguard Group (who owns six of the 10 largest mutual funds), Fidelity Investments and Charles Schwab Corporation.

Exchange-Traded Funds (ETFs) vs. Index Funds: Passive Mutual Funds

Index funds were created to be the passive arm of mutual funds. As such, index and mutual funds share many of the same traits and characteristics, especially in creation, capital raising and fee structure.

A fund manager starts by selecting a particular index or benchmark they want to mimic. The index fund then raises capital by selling shares to investors. Buying an index fund share is similar to owning a company’s stock. Instead of selling books or phones, index funds are the business of investing.

Since index funds are open-ended funds, they can issue an unlimited amount of new shares at any time. Typically, as long as there is demand, new shares will be issued by the fund. Being open-ended can result in the AUM of an index fund fluctuating regularly. When investors buy or sell index fund shares, the fund portfolio size increases or decreases proportionately.

Once enough capital is raised, the fund manager builds a portfolio by purchasing the various securities associated with the index or benchmark. Depending on the index or benchmark, an index fund can hold anywhere from a few dozen to a few thousand different underlying securities.

Similar to ETFs, index fund indexes and benchmarks are often more complex than just a particular industry or economic sector. Index funds can also focus on specific asset classes, styles and investment market caps.

A downside of index funds is that their shares are not traded on exchanges or OTC. Shares must be bought and sold from and to the fund itself or the fund’s broker. Individual shares’ buying and selling prices are determined by the net asset value (NAV) of the fund per share, alongside any additional fees. The value of a fund’s portfolio is only announced at the end of each trading day, which means transactions involving index fund shares can only occur at the end of each business day.

Investors can earn returns through dividend and interest payments from underlying securities, capital gains when the index fund sells a security at a profit or when the underlying portfolio increases value.

In rare cases, a fund may offer in-kind redemptions. Instead of cash, the fund will pay investors in securities or property. Typically, in-kind redemptions only occur when a fund is experiencing significant capital outflow.

Exchange-Traded Funds (ETFs) vs. Index Funds: Index vs. Mutual funds

Traditional mutual funds and index funds differ in portfolio management and expense ratios. Index funds are passively managed. Once an index fund is up and running, the fund manager is relatively hands-off. Instead of a portfolio manager and his team continuously selecting securities based on financial and economic analysis, the underlying portfolio automatically drops and adds securities to match the particular index or benchmark it is tracking. In exchange for less professional oversight, index funds are noticeably cheaper than mutual funds.

The average index fund maintains an expense ratio of 0.2%. The average expense ratio for a mutual fund is between 0.5% and 1.0%. However, like mutual funds, index funds can still possess investment minimums.

Exchange-Traded Funds (ETFs) vs. Index Funds: Share and Fee Structures

Unlike ETFs, as part of their fee structure, index funds charge shareholder fees. The fees are structured the same way as shareholder fees found on mutual funds, although at lower rates. The different fee structures can significantly impact potential returns, so it is vital to get a good understanding of them:

  1. Sales Charge (Load) on Purchases, also known as a front-end load, is a fee that occurs when an investor buys mutual fund shares, usually paid to the fund’s broker. A front-end load reduces an individual’s investment.
  2. Purchase Fees are similar to front-end loads, but instead of going to a mutual fund’s broker, it is paid directly to the fund managers. Purchase fees are typically found in funds with high investment transaction costs.
  3. Deferred Sales Charges (Load), also known as back-end loads, are the opposite of front-end loads and usually occur in contrast to one another. Back-end loads are charged when an investor cashes out his fund shares. Often, the longer an investor holds onto a mutual fund share, the smaller the back-end load.
  4. Redemption Fees are back-end fees that are paid to the fund managers instead of the fund broker. Redemption fees are capped at 2% by law.
  5. Exchange Fees can occur when an investor transfers his investment to another mutual fund in the same fund group or family of funds.
  6. Account Fees are account maintenance fees.

A unique aspect of index and mutual funds is that they can issue multiple categories of shares. While ETFs are limited to issuing only one share type, index funds and mutual funds can possess several. Share classes can offer differing fee structures, shareholder services and distribution arrangements. However, all categories are invested into the same fund and share the same investment strategy and objectives.

The number of share classes and the characteristics for each class will vary from fund to fund. Generally, Class A shares are front-end loaded, while Class B shares are back-end loaded.

In summary, index funds are passively managed mutual funds that pool money from investors to invest in securities. Index funds track a specified index or benchmark. Index fund shares can only be bought and sold at the end of the day and only from/to the fund and its designated broker. Share prices are priced by the NAV per share of the fund alongside fees. Index funds can also charge shareholder fees and possess investment minimums. Funds can issue multiple share classes, each with different benefits and costs.

Exchange-Traded Funds (ETFs) vs. Index Funds: Differences

Exchange-traded funds are considered a subset of index funds since they also track a particular benchmark or index. As a result, it can be challenging to spot the difference between the two, especially between passive ETFs and index funds. It is often easier to view the ETFs and index funds as separate entities in comparison.

ETFs can either be passively or actively managed. Both passive and active ETFs track a particular benchmark or index. A passive ETF seeks to mimic its benchmark or index as closely as possible. An active ETF treats its benchmark or index as a guideline that the fund manager can deviate from if they choose to do so.

Index funds are the passively managed subset of mutual funds. Similar to ETFs, they aim to track a particular benchmark or index as closely as possible. A fund manager creates the initial underlying portfolio by purchasing securities that mirror the specific index or benchmark the fund intends to track, taking a back seat once the fund is assembled.

Index funds are similar to active mutual funds in construction and structure. Fund shares can only be purchased and sold at the end of each business day from/to the fund itself or its broker. The fund’s NAV per share determines the share price alongside any fees. The buying and selling of shares impact the underlying portfolio’s size.

Since active and passive ETF shares are liquid enough for intraday trading on exchanges or OTC, it allows investors to short or purchase shares on margin. The underlying securities of an ETF are held in trust and are not impacted by the buying and selling of ETF shares. ETF shares can only be sold back to the fund when an individual accumulates enough shares to cash out a creation unit.

An investor can earn returns from ETFs through dividend and interest payments from the underlying securities, through capital gains when the ETF sells underlying security for a profit or sells ETF shares on exchanges or OTC after they rise in value.

Index fund investors earn returns in the same way. The one exception is that they must sell shares back to either the fund or fund broker.

In terms of fees, passive ETFs are the cheapest. Index funds fall in the middle and may possess investment minimums. Active ETFs are the most expensive.

Exchange-Traded Funds (ETFs) vs. Index Funds: When are ETFs Best?

Exchange-traded funds possess an advantage in trading fees. Although passive ETFs usually maintain slightly lower expense ratios, the cost difference may be more significant than it appears. Most major brokers have eliminated commissions on stock and ETF transactions, while brokerage fees can be relatively high for index and mutual funds.

ETFs are also better for investors looking for more hands-on control over the buying and selling of shares. By enabling intraday trading, ETFs allow investors to receive real-time pricing of shares and execute complex trade maneuvers (stop orders, limit orders, etc.) not available to index fund shareholders. Intraday trading also removes investment minimums from ETFs.

ETFs are more tax-efficient than index funds. When an investor buys an index fund share, the money received by the fund, outside of fees, is used to purchase securities to ensure the underlying portfolio’s size remains consistent relative to the number of shares issued. As a result, when an investor sells their shares back to the fund, the fund manager will likely have to sell underlying securities to pay back the investor. The sale of securities can result in realized capital gains, leading to an increased tax bill that is ultimately spread across all investors in the fund, even for those that did not sell any shares. Since ETF shares are traded on exchanges or OTC, individuals are not impacted by other investors’ actions.

Finally, ETFs are better for investors seeking active portfolio management. Active ETFs have become more and more popular since being introduced in 2008 and offer similar professional portfolio management as mutual funds. Learn more about the differences between mutual funds and active ETFs here.

Exchange-Traded Funds (ETFs) vs. Index Funds: When are Index Funds Best?

Index funds are better in categories with securities that pay high dividends. Since ETFs are trusts, they are required by law to accumulate dividends until the end of each quarter before paying them out. Index funds, however, have the flexibility to reinvest dividends or pay them out to their investors immediately.

Index funds are better for those looking to invest every penny. Index funds offer fractional shares. When an individual invests in an index fund, the fund converts the total dollar amount into shares—issuing fractional shares if the investment does not fully divide into whole shares. Individuals can invest their capital sooner while taking advantage of dollar-cost averaging.

Since asset values generally rise, buying smaller shares over a more extended period can save investors money. Fractional shares have only started to become available for ETFs recently.

Finally, index funds are better if an investor saves for retirement through a defined contribution plan like a 401(k) or 403(b). One of the most significant upsides of the index and mutual funds is that they can be bought through defined contribution plans. ETFs are generally unavailable for such programs. An added benefit is that the investment minimum for index funds is typically waived when fund shares are purchased through a retirement plan.

Exchange-Traded Funds (ETFs) vs. Index Funds: King of Passive Investing

Ultimately, what investors want to know is: which is the better investment? Exchange-traded funds or index funds? There is no one size fits all. The answer varies from person to person, situation to situation.

Although ETFs allow individuals to invest in actively managed funds, passive investing may be the better way to use them. Over 15 years, only 18% of active mutual fund managers beat their benchmarks.

The choice between passive ETFs and index funds is a difficult one. Both have their pros and cons.

Fractional shares are an underrated tool for retail investors. An extra half or a quarter of a share may not be a game-changer for institutional investors, but for retail investors, being able to purchase portions of shares consistently can make a significant difference in the long run. Individuals can invest their capital quicker to yield higher returns, especially with dollar-cost averaging.

The ace in the hole for index funds is the option to purchase shares through defined contribution plans. Most individuals participate in the financial markets to increase their retirement portfolios. The ability to grow a portfolio tax-free can increase compound returns dramatically. If an individual invested $1000 monthly with a 6.0% average annual rate of return, no employer match, over thirty years, a 401(k) would generate approximately $480,000 more than a brokerage account.

Intraday trading is a nice perk for ETF investors. However, for most long-term investors, the difference between buying and selling shares at noon versus the end of the business day is negligible.

Although ETFs are cheaper and more tax-efficient, the ability to grow investments tax-free along with dollar-cost averaging is likely to result in higher returns. Simply put, there is no clear right answer, but my personal preference is for index funds.

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