The ability to short-sell an index exchange-traded fund (ETF) illustrates a key difference between ETFs and mutual funds. Shares in an ETF are bought and sold on a public exchange, as the name implies. Shares in a mutual fund are bought or sold by the financial company that manages it.
For that reason, there's no way to short-sell a mutual fund.
The two types of investment share many characteristics. Both mutual funds and ETFs consist of a pool of money from many investors that is invested in a selection of stocks or other assets sold in the form of shares.
An index fund, whether it's a mutual fund or an ETF, invests in the stocks that are listed in a particular stock index, matching its weighting as closely as possible. It is a passive investment, meaning that its contents change only when the index is updated.
The investor's return should be virtually identical to the return of the index, minus the costs charged by the sponsoring company. ETFs are known for their low fees, but it should be noted that index mutual fund fees have been substantially lowered in order to compete.
Key Takeaways
- Index mutual funds and index ETFs both are comprised of shares in the stocks that make up a particular index, whether it's the S&P 500 Index or a specialized index such as the Vanguard Energy ETF.
- Like any mutual fund, an index mutual fund is bought and sold directly by the company that manages it. Shares are sold only after the market closes.
- Like any ETF, an index ETF can be bought and sold on an exchange.
Understanding ETF Index Funds
When you invest in an index fund, you are buying shares in a portfolio composed of stocks that are listed in a specific index.
This is a passive investment. There is no team of financial professionals behind the scenes deciding when to buy and sell shares. The contents of the fund, and its return to investors, are identical to those of the index.
You can buy index funds for numerous different indices, including the , the Dow Jones Industrial Average, and the Russell 2000. Or you can buy index funds for specific industries or sectors, such as the energy industry, technology, or gold.
Index funds reduce the risk of losses by spreading the investor's money equally among many companies. Few investors could buy equal amounts of shares in all 500 of the biggest U.S. companies but an S&P 500 Index fund gives that investor precisely that level of diversification.
The Biggest ETFs
Two of the three biggest ETFs by assets under management are S&P 500 Index Funds. They are SPDR S&P 500 ETF Trust and iShares Core S&P 500 ETF In third place is the Vanguard Total Stock Market ETF.
Short-Selling an ETF
The fact that shares in ETFs are traded on a public exchange gives them many of the same attributes that stock shares have. That includes short-selling.
Traders engage in shorting when they borrow stock, usually from a broker in order to then sell it to another party. Short sellers are betting that the stock's price will go down so that they can pay less money to buy it back and then return it to the party that lent it.
In a successful short sale, the short sellerprofits from the difference between the price at which the security was sold and the lower price at which it was bought back.
An index mutual fund, or any mutual fund for that matter, cannot be short-sold because its shares don't trade on the open market. They are bought from the company that issued it, and must be sold back to that company.
Other Trading Strategies
Investors are able to short sell an ETF, buy it on margin, and trade it. In other words, ETFs are traded and exploited like any other stock on an exchange.
Index ETF prices fluctuate throughout the trading day as the index that it is based upon rises or falls in value.
However, an ETF's price also depends on the forces of supply and demand. For this reason, an ETF might not track the market in perfect unison. Mostcome very close.
What's the Difference Between an Index ETF and an Index Mutual Fund?
Both are pools of money that are invested in stocks or other assets that are listed on a specific index. The fund mimics the index, and its performance should be identical.
There are a few differences:
- Index ETFs were known for having much lower expense charges and fees than mutual funds. This has changed, with many mutual fund fees being drastically reduced in order to compete with comparable ETFs. Before you invest in either, check the fund's "expense ratio."
- ETFs are traded on the open market. Mutual funds are bought and sold directly through the company that manages them.
- Some ETFs have tax advantages over some mutual funds because they trade less frequently, realizing capital gains less often. ETFs and mutual funds are treated identically by the IRS, so any taxable distributions from an index ETF and an index mutual fund should be virtually identical.
Are All ETFs Index ETFs?
No. Although the biggest and best-known ETFs track the major stock indexes, an enormous variety of ETFs is available, and some use benchmarks other than an index.
Broadly speaking, there are ETFs that invest in stocks, bonds, U.S. Treasury notes, commodities, and currencies. As of January 2024, there are ETFs that invest in cryptocurrencies.
There also are sector ETFs that invest in specific industries such as healthcare, energy, or real estate.
What Is a SPDR?
SPDR is an acronym for Standard & Poor's Depository Receipt. All of the ETFs with SPDR in their names are managed by State Street Global Advisors. The best-known is the SPDR S&P 500 ETF Trust (SPY), It was the first ETF, issued in 1993, and it remains the world's largest.
The Bottom Line
From the casual investor's viewpoint, there is little difference between an index ETF and a mutual fund ETF. The ETF might have lower fees, but that has changed, so check the expense ratio before you choose.
If you're an active investor, you're probably not investing in index ETFs. They are passively-managed investments.
Nevertheless, ETFs trade just like stocks and you can buy, sell, or even short them just like stock shares.
