Index funds are mutual funds or ETFs whose portfolio matches the components of a certain market index, such as the S&P 500 or Nasdaq. Different funds can follow the same index, so how come they don’t have the same prices?
Index funds following the same index don’t have the same price because each fund issues a different number of shares. So, a fund with a total value of the underlying index of $10 million and 10 million shares will have a lower price than a fund with the same underlying index but 1 million shares.
In this article, you’ll learn how index funds are priced and why funds following the same index may have different prices. You’ll also learn whether or not you should consider the price of the index fund when considering the fund you should invest in.
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Table of Contents
How Index Funds Are Priced?
Before we get into pricing, it’s important to understand that there are 2 types of index funds:
- Mutual index funds
- Exchange-traded index funds (ETFs)
These types are inherently the same, as they both provide investors with a pool of stocks they can invest in. However, there’s one key difference: how they trade. ETFs are traded like regular stocks on the exchanges throughout the day, whereas mutual funds are traded once a day only.
With that said, let’s see how mutual funds and ETFs determine their prices.
Index Mutual Funds Are Only Traded Once a Day
The prices of index mutual funds update once every day after the US markets close, typically between 4 pm and 6 pm EST.
The price of the fund’s shares is determined by subtracting the total value of all underlying assets with the liabilities, such as operating expenses, and then dividing that by the number of all outstanding shares.
After following this formula, you get the Net Asset Value (NAV). The NAV is the price a trader will pay the next day to purchase a single share of that fund.
- NAV = (assets-liabilities) / number of shares
The value for the securities is calculated based on the total value recorded at the end of that day.
When you decide to invest in an index mutual fund, you’ll do the transaction directly with the
owners of that fund.
ETFs Are Traded Throughout the Day
Unlike mutual funds, ETFs can be traded throughout the day on the exchanges just like a regular stock. Thus, their pricing works a little differently.
Since ETFs trade on the market like a stock, their prices change continually until the market closes. This means that its price will change rapidly based on demand. The price of ETFs depends on 3 factors:
- The value of the underlying index
- Costs of hedging exposure to them
- Demand for that particular ETF
- Number of fund shares
ETFs trade closer to their “fair value” in normal, competitive markets in which discounts or premiums are quickly arbitraged away.
The term “fair value” means that the ETF trades for a price close to the inherent value of the underlying securities. In this case, the price will change depending on how the value of the index changes during the day.
When buying an ETF, you’ll usually deal with secondary handlers like the exchange that the fund trades on instead of the creators and managers of the fund.
Why Index Fund Prices May Be Different?
Let’s consider all the different factors that go into determining a price for an index fund. Whether it’s a mutual fund or an ETF, we can conclude that the underlying value of the index isn’t the only determining factor for the price.
Thus, it’s normal to expect different funds based on the same index won’t have the same prices.
The most significant factor for an index fund’s price is the number of shares that it issues. For example, the Vanguard S&P ETF is priced at $413 (on 9th September 2021), while Schwab’s price for the same index ETF is $69.
That doesn’t mean Vanguard’s ETF is more valuable; it simply means that it has fewer shares in circulation, resulting in a higher price.
Keep in mind that you shouldn’t pay too much attention to the fund’s price, as no matter how much you pay for a share, the value of your shares will increase at the same rate.
So, if the index rises 5%, the value of your shares will also increase by 5%, no matter which fund of that particular index you’re invested in.
Other Factors That Can Affect Index Fund Prices
Apart from the number of shares in circulation, here are some other important factors that can cause price fluctuation between funds that follow the same index:
- Liabilities. In mutual funds, these refer to money owed to banks, pending payments, and any other charges or fees owed to associated entities. Since different funds cooperate with separate entities and pay varying fees, liabilities will have a unique effect on the final price of each mutual fund associated with a particular index.
- Demands. A particular ETF may have a demand that can have a significant impact on its price. Since multiple ETFs are based on the same index, the demand for each ETF can increase its price compared to competitors.
This process works the same way as with stocks. The more demanded a particular stock is, the more limited its supply becomes, leading to a price increase.
Index Funds Have Additional Costs
The index fund price isn’t the only cost you need to look at when you decide to invest, as there are some other costs you should pay attention to. Mutual funds and ETFs have different costs associated with them, as discussed below.
Mutual funds usually come with management fees, along with sales commissions that you pay each time you buy or sell fund shares. Management fees typically range from 1% to 5% of a fund’s asset value. Additionally, there also might be:
- Redemption fees if you sell shares shortly after you purchase them
- An account fee for maintaining your account if you haven’t invested in a long time
- 12-1b fee, which is an annual fee charged by most mutual funds for marketing
ETFs have much lower fees than mutual funds and typically only charge commission fees when you buy or sell them. However, these fees can add up quickly if you plan to consistently add smaller portions of cash into an index ETF.
How To Choose Between Index ETF and Index Mutual Fund?
There are advantages and disadvantages to both ETFs and mutual funds. You should consider investing in an ETF if you:
- Want lower fees
- Trade actively
- Want tax efficiency
Mutual Index funds would be ideal if:
- The ETF of an index trades thinly. An ETF or a stock trading thinly means that there aren’t enough buyers and sellers on the market. A mutual fund won’t be affected no matter what the demand for it is.
- You find a mutual fund with lower annual costs than an ETF.
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Conclusion
Different index funds following the same index can vary in price for a few reasons, the main one being the different number of shares that each fund has.
However, the price of the funds doesn’t impact their values, so you can expect the same returns or losses no matter which fund you invest in.
Apart from the price of shares, there are other costs associated with buying index funds, such as brokerage fees, commission fees, account fees, and others. Both index ETFs and index funds can be good options under different circumstances.
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