The various terms used to describe financial products can easily cause some confusion. ETFs, mutual funds, and index funds are three such terms which are easily confused as there is some overlap between their structure and purpose. 

This article should help you understand the different types of investment funds, and how they differ from one another.

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What is an ETF?

An ETF, or exchange-traded fund, is an investment vehicle that holds a portfolio of securities. ETFs are themselves listed and traded on a stock exchange, so they are bought and sold like shares. The advantage of this structure is that ETFs can be held in a stock trading account, and traded throughout the day.

ETFs are a fairly recent innovation and were first introduced in the 1990s.

What is a mutual fund?

Like ETFs, mutual funds are investment vehicles - however, the legal structure is quite different. A mutual fund represents a more direct relationship between an investor and the fund manager. All transactions are based on a single price each day, so the unit price doesn't fluctuate throughout the day.

Mutual funds pre-date ETFs, and have been around since about 1920.

How ETFs differ from Mutual Funds

The key differences between ETFs and mutual funds can be summarized as follows:

Share creation and redemption

ETF issuers appoint a market participant (usually a broker) to act as a market maker, and to create and redeem shares to satisfy supply and demand. This means investors can buy and sell ETF shares throughout the day at, or close to, the real-time net asset value (NAV). Because an ETF already exists when it is purchased by an investor, the fund does not incur further costs buying the underlying securities.

By contrast, when you buy or sell mutual fund units, the transaction is processed after the market next closes. New units will be created for you, and the price will be based on the NAV at the market close.

Fees

ETF investors pay a management fee (known as the expense ratio), and a commission to trade on an exchange.

Mutual fund investors also pay an annual management fee. Transaction fees and commissions may apply too, and depend on whether there is an intermediary or not. Some mutual funds also charge performance fees.

Trade size

The smallest possible investment in an ETF fund is the price of a single share. This makes ETFs very flexible for investors with small portfolios.

Mutual funds are typically subject to a minimum investment amount. This amount will depend on the fund, whether you invest through an intermediary, and whether you are making a once of investment or monthly investments.

Access

If you have a trading account with a stockbroker, you can trade any ETF listed on the exchanges the broker gives you access to.

There are two ways to invest in a mutual fund. You can invest directly via the management company – this will limit you to the asset manager’s range of funds. You can also invest via a fund platform; in which case you will have access to a larger but still somewhat limited range of funds.

Active vs passive management

ETFs and mutual funds can be managed actively or passively. If the fund is actively managed, the fund manager decides which securities to hold, and when to buy and sell them. The objective of an actively managed fund is to outperform a benchmark index. Investors pay higher fees to invest in active funds to cover the higher overheads.

By contrast, the objective of passively managed funds is to deliver the same returns as the index. To do this, the fund simply mirrors the index. Passive funds charge lower fees as they require fewer resources to manage.

What are index funds?

Strictly speaking, we could call any passively managed fund an index fund. However, in practice, the term index fund usually refers to a passively managed mutual fund. We can trace the reason for this back to the first index-tracking mutual funds. At the time, ETFs didn't exist and the terms active and passive weren't part of the investing landscape. The term index funds was coined to differentiate between mutual funds that tracked an index and the other mutual funds that were managed on a discretionary basis. So, until the first ETF was introduced, a fund was either a mutual fund or an index fund.

You may occasionally hear the terms index-tracking fund or index tracker. These terms would refer more generally to any fund that tracks an index, whether it’s an ETF or a mutual fund.

Active ETFs vs mutual funds

The investment industry has now come full circle with the emergence of actively managed ETFs. Passive ETFs have grown in popularity over the last two decades due to their flexibility and low fees. However, there is still a place for active investing. 

Passive funds are a cheap and efficient way to capture the performance of broad market indexes. However, to generate market-beating returns, investors need to consider slightly riskier strategies. These can include investing in emerging economies, industries, and investment themes. In these market segments an active strategy can be a better way to generate returns and manage risk than an index tracking strategy.

Active ETFs combine the advantages of ETFs with the flexibility of active management when investing in narrower market segments.

At present, most mutual funds are actively managed while most ETFs are passively managed. But a growing list of actively managed ETFs is now available to investors.

Conclusion

The introduction of index funds pioneered the concept of passive investing, but ETFs have since emerged as a more flexible investment vehicle. The popularity of both ETFs and passive investing has resulted in most new investments flowing to ETFs. The emergence of actively managed ETFs now gives investors another reason to choose an ETF instead of a mutual fund.