Lisa Whitley — For this short series of articles, we’ll explore the differences between common financial vehicles. Maybe you know already, perhaps you don’t; either way a rising tide lifts all boats!
So, what is the difference between… an index mutual fund and an exchange-traded fund (ETF)?
Just when you had mastered the intricacies of mutual funds, you were thrown a curve ball and offered the opportunity to invest in an exchange-traded fund (ETF). What’s the difference?
Both are low-cost ways to invest in a diversified pool of assets, usually stocks or bonds. Both seek to mirror the performance of an index, for example the S&P 500. The stocks held by a typical S&P 500 index mutual fund and an S&P 500 ETF are the same! But now the roads start to diverge…
The biggest difference that would likely matter to you is cost; that S&P 500 ETF likely has a lower fee than the S&P 500 index mutual fund. The difference may not be dramatic, but it does exist.
The other difference between the two options is how they are traded. When you buy (or sell) shares in a mutual fund, your order is not processed until after the trading day has ended; the price you pay (or receive) is the price at the end of the day. However, when you buy or sell shares within an ETF, that trade is executed immediately, just as if you were buying or selling an individual stock. For active traders, this can be important. For you, probably not so much.
For a typical retirement investor, either choice — index mutual fund or ETF — will serve you well. In fact, a workplace retirement plan may only offer one or the other. But if you have a retirement account outside of the workplace (an IRA), you may have the option of choosing either. As always, first reflect back on your investing goal. Then, choose the fund (or funds) that meet this objective, of whatever type.
As you might imagine, there are complications to this simple tale. Increasingly, there are more complicated ETFs available that invest in very narrow market sectors, or that use more risky leverage (debt) strategies to hopefully improve returns. As always, steer clear of what you do not understand well and consult experts.