The Difference Between Index Mutual Funds and ETFs

At heart, index mutual funds and ETFs aren't such different investments. Both rely on the performance of a collection of stocks to provide big returns for clients. That's where the similarities end, though; index mutual funds and ETFs trade differently and provide varying options for index investing.

What Are Mutual Funds and ETFs?
Mutual funds are big pools of money that investment managers use to purchase stocks or bonds. Index mutual funds are based on the performance of underlying indices, but actively managed mutual funds typically encompass a broad range of investments. Most mutual funds aim to beat the index.

ETFs are similar to mutual funds, in that they are large collections of a broad selection of stocks, but the similarity ends there. ETFs aren't actively managed, and they trade like stocks.

ETF Index Funds: More Flexibility to Traders, at a Price
Because ETFs can be bought and sold like any other stock, they offer significantly more flexibility to the average investor than mutual funds. You can buy or sell ETFs at any point throughout the day and get an idea of their value minute-by-minute as the stock market changes. Mutual funds, on the other hand, are valued only at the close of business, so you don't have as much flexibility to buy or sell when market conditions change.

Because ETFs trade like stocks, you don't have to worry about a minimum investment or any sales or commission charges beyond those charged by your brokerage. However, if you don't have a discount brokerage, you can face far more fees actively trading ETFs than with index mutual funds. One big hit is dividend reinvestment; most index mutual funds offer automatic dividend reinvestment, but with ETFs, you have to reinvest your dividends actively, thus incurring additional transaction fees. If you trade often, then ETFs might not be as good of a choice.

Index Mutual Funds Are Only As Good As the Managers
Because index mutual funds are actively managed, you need to shop around if you're considering investing in these index funds. If an index mutual fund is poorly managed, you could find yourself losing money compared to the underlying index. Twenty percent of index mutual funds outperform the corresponding indexes, leaving a whopping eighty percent to underperform.

Investing in Funds Carries Tax Consequences: ETFs for the Win
Tax consequences are a very real concern for the average investor, and ETFs hold a clear advantage over index mutual funds in this arena. Capital gains for index mutual funds are determined by management style and distribution, so you can't control them. Because ETFs trade like stocks, you have control over your capital gains; you can decide when to sell, and you determine the impact of capital gains.