Difference Between Index Mutual Funds and ETFs

Difference Between Index Mutual Funds and ETFs

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Jaya
Jaya Sharma
Assistant Manager - Content
Updated on Apr 8, 2024 18:25 IST

The main difference between Index Mutual Funds and ETFs is that Index Mutual Funds are bought and sold at Net Asset Value (NAV) prices at the end of each trading day, while ETFs trade like stocks on exchanges with prices that fluctuate throughout the trading day.

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Index Mutual Funds and Exchange-Traded Funds (ETFs) are both investment options that seek to track the performance of a specific index, such as the S&P 500 or NASDAQ. This blog will cover the main difference between Index mutual funds and ETFs.

Table of Contents

Difference Between Index Mutual funds and ETFs

While ETFs track the performance of the index, index funds replicate its performance.Let us now understand the difference between index mutual funds and ETFs.

Parameter ETFs Index Funds
Objective Tracking the index performance of indices Replicating the index performance
Trading Method Traded similar to stocks Index funds are issued like mutual funds
Factors affecting price Demand and supply  NAV of the fund and underlying assets
Cost Transaction fee  No transaction fee 
Expense ratio Low  High

About Index Funds

An index fund is a passively managed bond or stock portfolio that mimics market indices.This passive investment strategy aims to yield returns for the market. It is based on the theory that the market will outperform a single investment in the long run. Instead of choosing securities to invest in and before choosing when to buy or sell them, indexing happens. 

Fund managers will build a portfolio comprising holdings mirroring the securities of an index such as the S&P 500 index fund and Russell 2000 index. These funds aim to maximize the returns over the long run by avoiding buying and selling securities often. 

Financial firms try to match the performance of an index. If a stock makes up x% of an index, then the firm mimics the same composition by building 1% of its portfolio consisting of the stock.

Advantages of Index Funds

Through index funds, investors can experience the positive effect of diversification. It minimizes overall risk while increasing the expected return of a portfolio. For long-term investors, it is a great form of investment in the long term. These are the low-cost options that help in obtaining a well-diversified portfolio that can passively track an index. 

About Mutual Funds

Mutual funds are an investment scheme where fund managers invest money into various securities based on common objectives. The returns generated from this investment are distributed proportionately among investors post deduction of taxes if applicable. Mutual funds are ideal for those investors who do not have the expertise in how the market works. Experts utilize your money to yield maximum ROI. 

Related Read – Equity Linked Saving Scheme (ELSS)

Advantages of Mutual Funds

Mutual fund investments are safe since the capital is not invested in a single security. Instead, the money is invested at multiple places, due to which the risk minimizes or sometimes balances out. Say two of the five instruments face loss, but the rest are making positive returns. In such a condition, profit might be less, but it will be better than losing money.  

Types of Mutual Funds

There are two main types of mutual funds: open-ended and closed-end funds and actively or passively managed funds. 

1. Open-Ended

Open-ended mutual funds are subscription-based and do not have any lock-in or maturity period. There is no limit on the amount it can collect from the public. NAV is calculated on the value of underlying security daily at the end of the day. These gave higher liquidity than close-ended funds.   

2. Closed End 

The closed-end fund issues a fixed number of shares through a single IPO to raise capital for the initial investments. New shares can create no new shares, but these shares can be traded. Unlike open-end mutual funds, these are open for subscription during the initial offer period with a specific tenor and fixed maturity date. Overall, no new money flow is created into the fund. Both closed-end and open-end mutual funds distribute capital gains to the shareholders. In both mutual funds, an annual expense ratio is charged for the services. 

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3. Actively Managed Mutual Funds

Fund managers actively manage and monitor the portfolio in an actively managed portfolio. These professionals also decide which stocks should be bought and sold to get maximum returns on investment. 

4. Passively Managed Mutual Funds

A passively managed mutual fund follows the market fund without much involvement from the fund manager. They follow the benchmark index of the scheme in the exact same proportion.  

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About Exchange-traded funds (ETFs)

ETFs are pooled investment securities similar to mutual funds. They contain commodities, bonds, stocks, etc. Just like stocks, ETFs can be traded on a stock exchange. These can be structured in a way to track from prices of individual commodities to specific investment strategies. The prices of ETFs fluctuate throughout the trading day since they are traded on the exchange. 

Advantages of ETFs

ETFs are more cost-effective and liquid than mutual funds. They are helpful in diversification since these contain multiple underlying assets, such as thousands of stocks. These are marketable securities, which means that they have high liquidity. This allows ETFs to be bought and sold on the exchange throughout the day. ETFs can be used for speculation, price increases, income generation, and to hedge or set off risk in an investor’s portfolio. 

Types of ETFs

Different types of ETFs are available to investors for different purposes. 

1. Bond ETFs

Bond ETFs provide regular income to investors, whereas income distributions rely on the performance of underlying bonds. These are the ETFs that exclusively invest in bonds. These do not come with any maturity rate and trade at a premium or discount from the bond price. 

Such ETFs promote market stability by adding liquidity to the market. Bond brokers sell These over the counter and are traded throughout the day on a centralized exchange. In this type of ETF, investors are paid interest through monthly dividends and the capital gains are paid through an annual dividend. 

2. Stock Exchange ETFs 

These are the security that tracks indexes, sectors, commodities, stocks, etc. Any unsystematic risk associated with company stocks can be limited through these ETFs. Investors can purchase shares in these securities that trade on the stock market.

Prices of stock ETFs fluctuate throughout the day. Investors tend to invest in ETFs like the stock exchange since these are more cost-effective and liquid than mutual funds. These help investors gain exposure to equities and indexes without purchasing individual stocks. Such ETF shares are considered diversified assets since they provide access to a broad range of securities. 

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3. Commodity ETFs

Such ETFs invest in various physical commodities that help diversify the investor’s portfolio. Natural resources, precious metals, and agricultural goods are commodity ETFs. These reduce the risk while there is slow growth in the stock market. Here, the focus is on a single commodity held in physical storage. 

Commodity ETFs are useful for hedging against inflation. However, these also come with risks, just like other investments. These consist of asset-backed contracts that track the performance of a specific commodity. 

4. Currency ETFs

This is a pooled investment that provides exposure to exchange rates in one or more currency pairs. Investors can purchase currency ETFs on exchanges just like the shares of corporate stocks. These are passively managed and held in a single currency basket in one country.

Individual investors can gain exchange to the forex market through a managed fund without placing trades. These ETFs are useful in diversifying portfolios, speculation in the forex market, and hedging against currency risks. Investors can trade currencies during normal trading hours. 

5. Leveraged ETF

Leveraged ETFs use financial derivatives and debts to amplify returns on the underlying index. They can magnify a 1% gain in the S&P to a 2% or 3%. These ETFs track securities on a 2:1 or 3:1 ratio. Leverage ETFs use derivatives to magnify the exposure to a particular index, but it does not amplify the annual returns of an index.   

It is used by investors and traders who want to speculate on indexes to use short-term momentum to their advantage. Leverage ETFs are less used in long-term investments due to their high-risk and high-cost structure. 

Conclusion

We hope that through this article, you have understood the difference between index mutual funds and ETFs. You must know These three important sources of investments in depth before understanding the factors that distinguish them.

FAQs

Which one is better between ETF or mutual funds?

ETFs are considered better due to their higher liquidity, lower net fees, and higher tax efficiency than mutual funds.

Is it possible to lose money in index funds?

Yes, it is possible to lose money in index funds depending on the benchmark index. Any index fund that is associated with the benchmark index is subject to losses. However, one cannot lose the entire amount in this type of investment since it will mean that every stock has hit lossess, which is pratically impossible.

What are the disadvantage of ETFs?

These are traded on exchanges due to which there is a fee associated with ETFs such as brokerage. Investors are required to pay this fee every time a trade occurs. Many times, there is difficulty in tracking ETFs since they can stray away from benchmark for various reasons.

Are index funds suitable for retirement?

Index funds such as 401(k) and IRAs are considered to have ideal holdings for requirement accounts.

About the Author
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Jaya Sharma
Assistant Manager - Content

Jaya is a writer with an experience of over 5 years in content creation and marketing. Her writing style is versatile since she likes to write as per the requirement of the domain. She has worked on Technology, Fina... Read Full Bio