ETFs, mutual funds and index funds: what is the difference?

Funds let you own many investments through a single purchase. The terms ETF, mutual fund and index fund are often used as if they meant the same thing, but they describe different things, and they overlap. This article explains how each works, how they are traded, what they cost, and how to choose.

What a fund is

A fund pools money from many investors and uses it to buy a basket of investments, such as shares, bonds or both. Each investor owns a share of the pool. This gives you instant diversification and professional administration, in a single product, even if you only invest a small amount.

Mutual funds

You buy and sell mutual fund units directly with the fund company or through a platform. Orders are priced once a day, after the market closes, at the fund's net asset value, which is the total value of its holdings divided by the number of units. Mutual funds can be actively managed, where a manager chooses what to hold, or passive.

Practical points:

• You do not see the price move during the day. You get the end-of-day price.
• Some have minimum investments, though many platforms allow small amounts.
• Some charge sales loads or exit fees, so check the terms.
• They are convenient for regular investing, since many allow automatic monthly contributions in exact amounts.

ETFs

An exchange-traded fund trades on a stock exchange like a share. The price moves throughout the day, and you can buy or sell at any time while the market is open, through a broker. Many ETFs track an index, although some are actively managed.

Practical points:

• You pay a brokerage commission in many cases, and the spread between buy and sell prices.
• You can buy a single unit, or fractions through some platforms.
• Liquidity varies. Large, popular ETFs trade easily, while niche ones may have wide spreads.
• Intraday pricing is helpful for some but tempts others to trade too often.

Index funds

Index fund describes the strategy, not the wrapper. The fund holds the securities in an index, such as a broad market index, in order to match its return rather than beat it. An index fund can be structured either as a mutual fund or as an ETF. Index funds are usually low in cost, because they do not need a team of analysts.

Comparing the three

• Wrapper: mutual fund or ETF describes how the fund is structured and traded.
• Strategy: index (passive) or active describes how the holdings are chosen.
• You can therefore have an index mutual fund, an index ETF, an active mutual fund or an active ETF.

What to compare when choosing

1. Costs. The expense ratio, plus any trading commissions, spreads, loads or platform fees. Lower is better for similar funds.
2. What it holds. The index or strategy it follows, the number of holdings, and how concentrated it is in a few companies, sectors or countries.
3. Tracking difference. For an index fund, how closely its return follows the index after costs.
4. Size and liquidity. Very small funds can close, and thinly traded ETFs can have wide spreads.
5. Tax treatment. The way funds are taxed differs by country and sometimes between wrappers. Check the rules where you live, or ask a professional.
6. Distributions. Whether income is paid out or reinvested automatically (accumulating).
7. Currency. The currency of the fund and its underlying investments.

Be careful with specialised products

Some ETFs are narrowly themed, leveraged, or designed to move inversely to a market. These can behave very differently from what you might expect, particularly over periods longer than a day, and are generally unsuitable for long-term investing. Read the documents before buying anything you do not fully understand.

Which should you choose?

For a long-term investor who wants simple, diversified exposure, a low-cost index fund in either wrapper is a common choice. Choose the wrapper that fits how you invest: mutual funds suit automatic monthly contributions, while ETFs suit those who want exchange trading and a wide choice of low-cost products. The difference in outcome is usually smaller than the difference in costs and in your own behaviour.

Common mistakes

• Choosing a fund on last year's performance alone.
• Ignoring the expense ratio and trading costs.
• Buying several funds that hold the same underlying shares, which adds cost without adding diversification.
• Using complex or leveraged ETFs as long-term holdings.
• Trading ETFs too often because prices are visible all day.

A short checklist

• I understand whether I am buying a mutual fund or an ETF.
• I know the index or strategy, and the total cost.
• I have checked what the fund holds.
• I know how it is taxed where I live.

The labels matter less than what a fund holds and what it costs. Understand those two things first.