ETFs vs. Index Mutual Funds: What's the Difference?

ETFs vs. Index Mutual Funds: An Overview

Both exchange-traded funds (ETFs) and index mutual funds are popular forms of passive investing, a term for any investment strategy that avoids the cost of an active human team by trying to match—not beat—the performance of the market. Unlike active investing strategies, which require expensive portfolio management teams focused on beating stock market returns and taking advantage of short-term price fluctuations, passive strategies like ETFs and index funds seek only to replicate the performance of a financial market index (like the S&P 500).

Of note, passive strategies like ETFs and index funds have grown dramatically in popularity vs. active strategies—not only due to the cost benefits of lower management fees, but also due to higher returns on investment. Investment research firms report that few (if any) active funds perform better than passive funds over the long term.

Index investing has been the most common form of passive investing since 1975, when Vanguard founder Jack Bogle created the first index fund. ETFs (the second most popular form of passive investing) have grown significantly since they were first launched in the 1990s as a way to allow investment firms to create “baskets” of major stocks aligned to a specific index or sector.

Both ETFs and index funds are pooled investment vehicles that are passively managed; the key difference (discussed below) is that ETFs can be bought and sold on the stock exchange (just like individual stocks)—and index funds cannot.

Exchange-Traded Funds (ETFs)

As a pooled investment vehicle, an exchange-traded fund (ETF) is a “basket” of stocks, bonds, or other assets that gives the investor exposure to a diverse range of assets. For example, ETFs can be structured to track anything from a particular index or sector to an individual commodity, a diverse collection of securities, a specific investment strategy, or even another fund.

Unlike index funds, ETFs are flexible investment vehicles that are highly liquid: they can be bought and sold on a stock exchange throughout the trading day, just like individual stocks. Because investors can enter or exit whenever the market is open, ETFs are attractive to a broad range of the investing public, including active traders (like hedge funds) as well as passive investors (like institutional investors).

Another feature that attracts both active and passive investors is that certain ETFs include derivatives—financial instruments whose price is dependent on (a derivative of ) the price of an underlying asset. The most common ETF derivatives are futures—agreements between buyer and seller to trade certain assets at a predetermined price on a predetermined future date.

Another benefit of ETFs is that—because they can be traded like stocks—it is possible to invest in ETFs with a basic brokerage account. There is no need to create a special account, and they can be purchased in small batches without special documentation or rollover costs.

Index Funds

An index fund is any investment fund that is constructed to track the components of a financial market index (including any ETFs that are index-aligned). Index funds must follow their benchmarks without reflecting market conditions—and orders can be executed only once a day after the market closes—so they have much less liquidity and much less flexibility than ETFs. 

As the original passive vehicle, the investing strategy behind an index fund is that a portfolio that matches the composition of a certain index (without variation) will also match the performance of that index—and the market will outperform any single investment over the long term.

An index fund can track any financial market, from the S&P 500 (the most popular in the U.S.) and the FT Wilshire 5000 Index (the largest U.S. equities index) to the Bloomberg Aggregate Bond Index, the MSCI EAFE Index (European, Australasian, and Middle Eastern stocks), the Nasdaq Composite Index, and the Dow Jones Industrial Average (DJIA) (30 large-cap companies).

For example, an index fund tracking the DJIA invests in the same 30 companies that comprise that index—and the portfolio changes only if the DJIA changes its composition. If an index fund is following a price-weighted index—an index in which the stocks are weighted in proportion to their price per share—the fund manager will periodically rebalance the securities to reflect their weight in the benchmark.

Although they are less flexible than ETFs, index funds deliver the same strong returns over the long term. Another benefit of index funds that makes them ideal for many buy-and-hold investors is their simplicity. For example, index funds can be purchased through an investor’s bank, with no need for a brokerage account—and this accessibility has been a key driver of their popularity.

Key Differences

In addition to the flexibility and liquidity differences noted earlier, ETFs and index funds have a few significant cost differences. Compared to actively managed funds, both these passive vehicles are low-cost investment options, but each has cost advantages and disadvantages associated with their different approaches to index tracking and trading, including redemptions, cost drag, dividend policy, and taxation. Overall, the structural differences between the two investment vehicles give ETFs a cost advantage over index funds.

For example, ETFs have lower redemption fees than index funds. Redemption fees are paid by an investor whenever shares are sold, so the constant rebalancing that occurs within index funds results in explicit costs (e.g., commissions) and implicit costs (trade fees). ETFs avoid these costs by using in-kind redemptions; rather than monetary payments for exited securities, ETFs pay with in-kind positions in other securities—a strategy that also avoids taxes on capital gains.

Another cost difference between ETFs and index funds is that ETFs have less cash drag: a type of performance drag that occurs when cash is held to pay for the daily net redemptions that happen in index funds. Cash has very low (or even negative) real returns due to inflation, so ETFs—with their in-kind redemption process—are able to earn better returns by investing all cash in the market.

Index funds have a cost advantage over ETFs when it comes to dividend policy, because dividends are reinvested automatically, which allows investors to maximize compound growth. ETFs accumulate dividends until the end of the quarter, and then distribute them to investors either as cash or as shares of the ETF.

Another important difference is that, although ETFs and mutual funds are both subject to tax on capital gains and dividend income, ETFs are more tax efficient than index funds because they are structured to have fewer taxable events. As mentioned previously in this article, an index fund that must constantly rebalance to match the tracked index generates taxable capital gains for shareholders. The structure of an ETF minimizes taxes by trading baskets of assets, which protects the investor from exposure to capital gains on any individual security in the underlying structure.

Special Considerations

The relative benefits and drawbacks of ETFs vs. index funds have been debated in the investment industry for decades, but—as always with investment products—the choice depends on the investor. Typically, the choice will come down to preferences on management fees, shareholder transaction costs, taxation, and other qualitative differences.

Most retail investors (non-professional, individual investors) prefer index funds. Despite the lower expense ratios and tax advantages of ETFs, retail investors prefer index funds for their simplicity and their shareholder services (like phone support and check writing) as well as investment options that facilitate automatic contributions.

While increased awareness of ETFs by retail investors and their financial advisers grew significantly through the 2010s, the primary drivers of demand have been institutional investors seeking ETFs as convenient vehicles for participating in (or hedging against) broad movements in the market. The ease, speed, and flexibility of ETFs allow the superior liquidity management, transition management (from one manager to another), and tactical portfolio adjustments that are cited as the top reasons institutional investors use ETFs.