Comparing ETFs and Index Funds

Exchange-traded funds (ETF) and index mutual funds cater to passive investors that seek relief from excessive commissions and losses arising from financial mismanagement. Passive investors invest for the long-term and match structures of the overall economy to their portfolio. This strategy rejects the idea of trading frequently in an attempt to outperform the stock market. You should learn to differentiate between ETFs and index funds, prior to committing to passive investment decisions.

ETFs and Index Funds: Identification

Mutual funds are investment pools for smaller investors that are managed by financial professionals. Index mutual funds are mutual funds that represent portfolios that match the composition of stock market indexes. Stock market indexes are benchmarks, or comparison standards for the overall stock market and economy. Exchange-traded funds are investment pools that trade upon public exchanges. ETFs usually hold portfolios that track stock market indexes. You buy shares in either type of fund to claim partial ownership over the investment pool.

ETFs and Index Funds: Acquisition

You will purchase open-end index funds directly through the fund company, or from a broker acting on behalf of that company. Index funds charge loads and management fees as percentages. These acquisition costs may be less than one percent of the total investment, annually. ETF's can be bought and sold throughout the day by paying flat-rate commissions to brokers. Smaller investors should target mutual funds for their lower acquisition costs. For example, more than ten percent of a $50 investment in ETFs would be lost with trading commissions.

ETFs and Index Funds: Trading

ETFs can either be sold short, or purchased on margin with brokerage accounts. Selling short is the process of borrowing an investment to sell for cash, before buying the same investment back to replace the original loan over time. Short sellers hope for price declines. Short sales are done as part of margin accounts that allow you to borrow money from the brokerage to buy investments. Index funds cannot be traded in this capacity.

ETFs and Index Funds: Valuations

Index mutual funds are bought and sold at net asset value (NAV), which is calculated by dividing the total assets of any investment pool by its shares outstanding. Index mutual funds calculate NAV once per day at the end of the trading session. Conversely, exchange traded funds regularly fluctuate in price with the overall market. ETF valuations may deviate somewhat from the underlying NAV.

ETFs and Index Funds: Internal Costs and Taxes

ETFs feature lower internal costs than index mutual funds because ETFs are not forced to sell securities to meet redemptions when investors cash out. The reduced trading activity is also more tax efficient than mutual funds. Mutual fund investors are responsible for paying taxes upon capital gains distributions. Capital gains occur when the mutual fund sells stock within the portfolio at a profit.

Comparing ETFs and Index Funds, Sources:

Bloomberg, Movers By Index, http://www.bloomberg.com/markets/stocks/movers_index_ibov.html

Yahoo! Finance, Exchange-Traded Fund Center, http://finance.yahoo.com/etf

Bloomberg, Top U.S. ETFs by Sector, http://www.bloomberg.com/markets/etfs/

The Standard and Poors 500 Equity Index, http://www.standardandpoors.com/indices/sp-500/en/us/?indexId=spusa-500-usduf--p-us-l--