Index Funds and Market Structure
Index mutual funds are priced at daily NAV and do not trade on exchanges — they are purchased and redeemed through the fund company. These transactions are not subject to PFOF. However, the index fund manager trades in the underlying securities to track the index, and those institutional trades are executed in markets where market structure matters.
Index ETFs and PFOF
Index ETFs trade on exchanges throughout the day like stocks. When retail investors buy or sell ETF shares through a discount broker, those transactions are subject to PFOF routing to wholesale market makers including Citadel Securities. The ETF transaction (buying/selling the ETF shares) is subject to PFOF; the underlying fund manager's trades (rebalancing the ETF's holdings) are not.
The Case for Passive Investing Despite PFOF
Despite PFOF-related execution costs, passive index investing remains one of the most effective strategies for most retail investors. Academic research consistently finds that passive strategies outperform active stock-picking over long periods, primarily because of lower costs and the difficulty of consistently predicting market movements. PFOF adds a small cost but does not negate the fundamental case for passive investing.
Minimizing Costs for Index Investors
Index investors can minimize market structure costs by: using limit orders when buying/selling ETFs rather than market orders; choosing ETFs with tight bid-ask spreads (typically large-cap ETFs like SPY, QQQ); and trading during peak market hours when liquidity is highest and spreads are narrowest. These steps can modestly improve outcomes over a long investing career.