While similar in many respects, an index mutual fund (IMF) and an exchange-traded fund (ETF) are different. This article will focus on that difference with the objective of determining which of the two is more suitable to an investor’s needs. Here’s a hint right up front — it depends on what kind of an investor you are.

Passive Management

For our purposes here, remember that both IMFs and the vast majority of ETFs are managed passively, i.e. they are tied to a market index that the fund tracks.

For example, for IMFs and ETFs the money going into the widely used S&P 500 is automatically, and mechanically, invested proportionately into stocks in the fund according to the percentage of their market-capitalization weight. If IBM’s market-cap represents 1.7% of the S&P 500 Index, for every $100 invested in either an IMF or ETF tracking this index, $1.70 goes into IBM stock. It is a matter of record that indexing has been able to outperform the majority of actively managed funds — the precise percentage varying from one year to another is between 60 to 80%.

Most investment professionals would agree that the active-passive management issue does not require an either/or decision. Both types of fund management have a place in a fund investor’s portfolio. However, if IMFs and ETFs sound like the same animal, they are not: the IMF is a mutual fund and the ETF is a stock.

The Distinction that Makes a Big Difference

The only difference between an IMF and a conventional mutual fund is its form of management: the former uses indexing and the latter uses a human element to make investment decisions. IMFs have been around since John Bogle. the founder of Vanguard, created the index mutual fund back in the mid-1970s. In 2010, 359 IMFs account for a little less than $1 trillion of $12 trillion of mutual fund assets in the United States.

ETFs were created in the late 1990s in response to the desires of professional and institutional investors for sophisticated active trading of market-based funds, which can’t be done with the traditional mutual fund, whether indexed or managed. ETFs are different from IMFs in that they are structured as stocks, listed on stock exchanges and therefore traded like stocks.

The pros wanted buying and selling flexibility, which is an euphemistic phrase that covers programmed and intra-day trading, taking short positions, buying on margin. and using arbitrage pricing and options. In the early years, ETFs typically used broad market segment indexes, such as the S&P 500 and the Russell 2000, in the same fashion as IMFs. Then, during the 2000s, the ETF industry cranked up its promotional machine. The result? ETF sponsors have designed hundreds of untested, complex and often narrowly focused indexes that have produced an avalanche of ETFs. In 2001, there were 118 ETFs — it appears that at year-end 2010 there will be close to 1,100 worth over $1 trillion.

Make no mistake; most ETFs have been created for active traders and not buy-and-hold. long-term individual investors. With some exceptions, ETF investors are trying to beat the market and IMF investors are trying to match the market.

What the Experts Have to Say

In his book, Don’t Count On It (John Wiley & Sons, 2010), John Bogle acknowledges that broad-market based ETFs that track fundamentally sound indexes have merit for the average investor. However, he’s on record observing that … while it’s easy to see how ETFs serve short-term stock traders, it’s difficult to see how they serve long-term investors significantly more effectively than the classic, low-cost regular index fund.

Not surprisingly, Charles Schwab is an enthusiastic proponent of ETFs. Schwab is quoted in a Barron’s article on ETFs as saying, There is no better way for individuals to build diversified portfolios. Every asset class is available at rock-bottom costs. In the same Barron’s issue, the Editor’s Letter puts its publication’s blessing on Schwab’s ETF endorsement by saying that we’ve always believed that smart individuals and their advisors can beat the market.

The Wall Street Journal financial columnist, in this case J. Alex Tarquinio, has a more circumspect view of ETFs. Tarquinio is critical of the more arcane, niche-oriented products, which represent the vast number of ETFs being rolled out in recent months. His concern is focused on the rapid rate ETFs have been closing in 2008-2010: About 140 have shut down since the beginning of 2008 — that’s roughly the equivalent of 900 traditional funds closing. (By comparison, only 10 ETFs closed in the previous 15 years).

David Fry is founder and publisher of ETF Digest and a best-selling author and frequent commentator on ETF topics. He’s a veteran of some 35 years in the business of stock trading and portfolio management. His article, How To Safely Navigate Through Crowded ETF Waters, (AAII Journal. October 2010) is a balanced assessment of the ETF market, and applicable to the interests of both non-professional and professional investors. His concluding remarks to this piece are worth noting: The good news is that the heavy issuance of exchange-traded funds creates opportunities for investors that heretofore never existed. The bad news is that investors will have to work harder to separate the wheat from the chaff.

The Bottom Line

So, what kind of investor are you. Using an automotive metaphor might help you answer the question and steer you in the right direction. If you’ve been driving a Toyota Corolla and getting from point A to point B without much of a hassle, stick with a Corolla-like (simple, easy to drive) index mutual fund vehicle. Readers should note that, as has been mentioned here, there are a small number of exchange-traded funds that track traditional, broad-based market indexes with established track records that also fall into this category.

But, if you yearn for the thrills and performance of a Maserati-like (risky, highly engineered) ETF, and you know how to drive one, then some of the ETFs created in the late 2000s are the ones for you. It’s worth remembering that the index mutual fund may look like the tortoise and the exchange-traded fund like the hare in Aesop’s fabled race, and we all know how that one turned out.