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Many companies offer index funds and ETFs. If two funds or ETFs track the same fund, what differentiates the two? Is it common for one index fund to outperform another? How can this happen if the funds/ETFs are tracking the same index?

I found this post comparing index funds and ETFs. When forced to choose between them, index ETFs look like the better option (under the right circumstances), but what differentiates index funds/ETFs when compared to similar vehicles?

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3 Answers 3

up vote 12 down vote accepted

Index Funds & ETFs, if they are tracking the same index, will be the same in an ideal world. The difference would be because of the following factors:

  1. Expense ratio: i.e. the expense the funds charge. This varies and hence it would lead to a difference in performance.

  2. Tracking error: this means that there is a small percentage of error between the actual index composition and the fund composition. This is due to various reasons. Effectively this would result in the difference between values.

  3. Demand / Supply: with ETFs, the fund is traded on stock exchanges like a stock. If the general feeling is that the index is rising, it could lead to an increase in the price of the ETF. Index funds on the other hand would remain the same for the day and are less liquid. This results in a price increase / decrease depending on the market.

The above explains the reason for the difference.

Regarding which one to buy, one would need to consider other factors like:

a) How easy is it to buy ETFs? Do you already hold Demat A/C & access to brokers to help you conduct the transaction or do you need to open an additional account at some cost.

b) Normally funds do not need any account, but are you OK with less liquidity as it would take more time to redeem funds.

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I think that assuming that you're not looking to trade the fund, an index Mutual Fund is a better overall value than an ETF. The cost difference is negligible, and the ability to dollar-cost average future contributions with no transaction costs. You also have to be careful with ETFs; the spreads are wide on a low-volume fund and some ETFs are going more exotic things that can burn a novice investor.

Track two similar funds (say Vanguard Total Stock Market: VTSMX and Vanguard Total Stock Market ETF: VTI), you'll see that they track similarly.

If you are a more sophisticated investor, ETFs give you the ability to use options to hedge against declines in value without having to incur capital gains from the sale of the fund. (ie. 20 years from now, can use puts to make up for short-term losses instead of selling shares to avoid losses)

For most retail investors, I think you really need to justify using ETFs versus mutual funds. If anything, the limitations of mutual funds (no intra-day trading, no options, etc) discourage speculative behavior that is ultimately not in your best interest.

EDIT: Since this answer was written, many brokers have begun offering a suite of ETFs with no transaction fees. That may push the cost equation over to support Index ETFs over Index Mutual Funds, particularly if it's a big ETF with narrow spreads..

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I'm assuming the question is about how to compare two ETFs that track the same index.

I'd look at (for ETFs -- ignoring index funds):

  • liquidity -- how many shares trade daily
  • expense ratio
  • discount/premium
  • structure of the fund -- how closely do they have to track it, do they own all components, how much can they hedge, etc
  • reputation of the issuer

So, for example you might compare SPY vs IVV:

  • SPY has about 100x the volume. Sure, IVV has 2M shares trading, so it is liquid "enough". But the bigger volume on SPY might matter to you if you use options: open interest is as much as 1000x more on SPY. Even if you have no interest in options, the spreads on SPY are probably going to be slightly smaller.

  • They both have 0.09% expense ratios.

  • When I looked on 2010-9-6, SPY was trading at a slight discount, IVV was at a slight premium. Looking for any sort of trend is left as an exercise to the reader...

  • Grab the prospectus for each to examine the rules they set for fund makeup.

  • Both come from well-known issuers and have a decent history. (Rather than crazy Uncle Ed's pawn shop, or the Central Bank of Stilumunistan.)

So unless you find something in the SPY prospectus that makes you queasy, the higher volume and equal expense ratios would seem to suggest it over IVV. The fact that it is at a (tiny) discount right now is a (tiny) bonus.

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