ETFs compared: ETFs vs mutual funds vs index funds

Investors who want to add diversification to their savings often look to funds to quickly add a variety of assets to their portfolios. Funds allow investors to buy into ready-made, diversified investments without having to research and purchase individual stock choices.

Investors have options including Exchange-Traded Funds (ETFs), actively-managed mutual funds and index funds. These three investment vehicles share a number of similarities, but understanding where they differ will help you determine which one best fits your savings plan.

The right fund is one that matches your investment goals, strategy and preferences. There are many ways to invest in today’s market. Knowing how they compare will help you find the right fund for you.

ETF comparison in Canada

ETFs

While there are many types of ETFs (Exchange-Traded Funds) available, they are primarily passive investments that aim to track a benchmark such as the S&P 500 or the S&P/TSX Composite Index, a bond market, an industry or a commodity. [1] They may also track any kind of index designed to meet other goals, such as a sustainable investing index. The fund tracks an index’s performance by purchasing a variety of assets on the respective index or in the target sector. ETFs trade like other stocks and can be found on exchanges around the world.

What is a mutual fund?

Mutual funds are professionally managed investment vehicles that offer investors a diversified portfolio at a relatively low cost. They can be held in both registered and non-registered plans, and they provide access to opportunities in a variety of sectors and industries around the world.[2] Mutual funds are not traded on exchanges, and there are limitations on when and how often you can buy or sell a stake in them.

What is an index fund?

An index fund is a type of mutual fund that tracks an index’s performance. [3] Index funds share many similarities with most ETFs. You can even find index funds and ETFs that track the same indices. Both are often passively-managed investment vehicles, but there are important differences in terms of how they are traded and the expenses involved.

Mutual funds vs ETFs in Canada

Differences between a mutual fund and ETF

The most significant differences between mutual funds and ETFs tend to come from pricing, liquidity, tax efficiency and costs. [4] Identifying the attributes that will best work with your investment habits and strategy will help you determine whether you should invest in a mutual fund or an ETF.

Passive ETFs are usually considered more tax-efficient than mutual funds. [6] When any kind of fund sells an asset after it has appreciated in value, the fund creates a capital gain and will have to pay capital gains taxes. Both types of funds may sell an asset to rebalance their portfolio. However, mutual funds may also have to sell assets to meet redemptions from shareholders. ETFs avoid this situation because shares are sold on exchanges between investors. This means they tend to accrue fewer capital gains taxes, the cost of which eats into shareholder returns. [7]

Similarities between ETFs and mutual funds

Choosing between an ETF or mutual fund: Pros & cons

Choosing between a mutual fund or ETF depends on your preferences and the composition of your portfolio. But ETFs may fit your strategy if you want to trade more actively, want exposure to specific industries or commodities, want to take advantage of an ETF’s better tax efficiency, or don’t have the minimum investment for a mutual fund. A low-cost ETF can help investors who want to match a market or industry with minimal management and fees.

On the other hand, the goal of an actively-managed fund is to deliver better results than the market, whereas passively managed funds will not outperform the market by design. However, they may have higher fees, may be less tax-efficient, and there is no guarantee that they will grow faster than a passive fund.

Both ETFs and mutual funds are available through Scotia iTRADE.

Costs

Actively-managed mutual funds have higher operating costs than passive investments like ETFs as they require more time, research and analysis of assets from fund managers and their teams.

Flexibility

The freedom to trade ETFs the same way stocks are traded makes them a more flexible investment. Mutual funds can only be traded once a day, but this is usually not a major concern for long-term investors who aren’t making withdrawals or trading on a regular basis.

For beginners

ETFs and mutual funds can both help beginner investors get started. ETFs are a low-cost entry to robo-advisors that automate investment decisions, while mutual funds put your savings in the care of a professional fund manager. Neither type of investment requires your active attention or research.

ETFs vs index funds in Canada

Differences between index funds vs ETFs

Index funds are indexed mutual funds. [15] They invest in an underlying index, such as the S&P 500 or the Dow Jones Industrial Average. They rely on a passive investing strategy that removes the risk that an active fund manager will make the wrong decision. Instead, the fund owns a representative basket of assets designed to meet its benchmark.

Due to the way these funds are structured, ETFs tend to be more tax-efficient than index funds. [17] ETF shares are traded on the stock exchange, and investors exchange shares between them. When an investor withdraws their money from a mutual fund, including index funds, it must be redeemed from the fund manager. The fund must sell assets to generate the cash, incurring a capital gains tax that the fund pays. These transactions can reduce an index fund’s returns.

Index funds make it simpler to make smaller, regular contributions to your savings. When you purchase shares in an ETF, you usually have to pay a trading commission. [18] It can be more economical to use an index fund if you want to make automated contributions. Some ETFs allow investors to make pre-authorized, automatic contributions without commissions, but it is not universal.

Similarities between ETFs and index funds

Choosing between an ETF or index fund: Pros and cons

Volume

Trading volume can play a more important role in ETF investing than index funds. [20] Because ETFs trade as stocks, you rely on another investor to purchase your position when you sell your investment. This can become a concern with niche ETFs that have a low trade volume.

When you sell out of an index fund, the fund sells assets to redeem your investment. Trading volume is less of a concern.

Long term vs short term goals

Differences in trading volume and liquidity will not matter as much to long-term investors. Liquidity is more important for investors who are making frequent trades. Both ETFs and index funds are useful tools for long-term retail investors due to the long-term average returns of markets.

Investing vs trading

Like other mutual funds, index funds can only be traded when the markets have closed. While intraday trading should be approached with caution, ETFs are better suited to the practice because they can be sold like stocks.

Simplicity

One advantage of index funds is their simplicity. They are an investment you can set and forget and often appeal to new investors. ETFs can be used as a straightforward, long-term investment, but they can also lend themselves to more complex trading strategies.

Combining ETFs with index funds

As you build your portfolio and your savings increase, it may make sense to combine both ETFs and index funds. If you started investing with the simpler, more convenient index funds, you could add ETFs as you begin to take advantage of the lower costs or more advanced trading options.