A 45-second read by Anthony Benante, CFA: There are many factors to consider when comparing an exchange-traded fund (ETF) and an index mutual fund. An ETF is a marketable security that tracks an index, like an index fund. A Mutual Fund is an investment company that pools money from shareholders and invests in a variety of securities, including stocks, bonds and money market funds. A main difference between an ETF and an index mutual fund is an ETF trades continuously while the market is open, while the index mutual fund trades one time a day at market close.
For ETFs, investors should be aware of the spread between the bid and the ask price. The larger the spread, the higher the implied cost is for investing in the ETF. Also, investors need to understand the strength and depth of the ETF to make sure there is ample liquidity during volatile markets. Investors can research the daily volume traded, the overall size of the ETF and other factors to better understand the strength of the ETF. Finally, be aware of any differences between the liquidity of the investments that make up the ETF and the actual liquidity of the ETF itself. All these factors can lead to the ETF performing differently than its benchmark.
Index mutual fund performance will not perfectly match its benchmark either. The costs to run the fund, which are paid by the investor and identified as an expense ratio (ETFs have similar costs) negatively impact performance compared to a benchmark index. Also, index mutual funds may be required to hold a portion of the fund in cash to meet investor redemptions, which could contribute to lower relative performance when the benchmark’s performance is positive.
Investors may experience different costs for the same product, meaning you have to do your homework. Some ETFs can have transaction costs, however, some brokerages allow for free trading for certain ETFs. For index mutual funds, you may be able to go direct to a mutual fund company and invest with no transaction cost, but you could pay transaction charges in a brokerage account for that same fund, depending on where the account is held.
In general, active investors may prefer the trading flexibility offered from ETFs, while long-term buy and hold investors may prefer using a straight index mutual fund to gain exposure to a specific benchmark. We encourage investors to do their research and seek help in areas outside of their expertise.
If you have any further questions on the subject, please reach out to your Baron Team.
Disclosure: Past performance is no guarantee of future results. Every investment strategy has the potential for profit or loss. This material is not intended to be relied upon as a forecast, research or investment advice.