Index Fund vs. ETF: An Overview
Exchange-traded funds (ETFs) and index funds are similar in many ways but ETFs are considered to be more convenient to enter or exit. They can be traded more easily than index funds and traditional mutual funds, similar to how common stocks are traded on a stock exchange.
Investors can also buy ETFs in smaller sizes and with fewer hurdles than mutual funds. They can avoid the special accounts and documentation required for mutual funds by purchasing ETFs.
Key Takeaways
- Mutual funds are pooled investment vehicles managed by a money management professional.
- Exchange-traded funds (ETFs) represent baskets of securities that are traded on an exchange like stocks.
- ETFs can be bought or sold at any time.
- Mutual funds are only priced at the end of the day.
- Overall, ETFs cost less and are more tax-efficient than similar mutual funds.
Index Mutual Funds
Index funds are funds that represent a theoretical segment of the market. They're designed to act as the performance and make-up of a financial market index. You can't invest in an index itself but you can invest in an index fund. You're utilizing a form of passive investing that sets rules by which stocks are included and then tracks the stocks without trying to beat them.
These types of funds follow a benchmark index like the Nasdaq 100 or S&P 500. Index funds have lower expenses and fees than funds that are actively managed.
Those who are interested in investing in an index fund can generally do so through a mutual fund that's designed to mimic the index.
Exchange-Traded Funds (ETFs)
ETFs are baskets of assets that are traded like securities. They can be bought and sold on an open exchange just like regular stocks. Mutual funds are only priced at the end of the day.
Other differences between mutual funds and ETFs relate to the costs associated with each. There are typically no shareholder transaction costs for mutual funds. Costs such as taxation and management fees, however, are lower for ETFs. Most passive retail investors choose index mutual funds over ETFs based on cost comparisons between the two. Passive institutional investors tend to prefer ETFs.
More ETF options are available beginning in 2024 and this might make them a more attractive investment. TheSecurities and Exchange Commission(SEC) approved 11 new ETFs to be listed on
the NYSE Arca, Cboe BZX, and Nasdaq exchanges beginning on Jan. 11, 2024. These are the first spot market bitcoin ETFs to ever be listed.
Financial experts consider index fund investing to be a rather passive investment strategy compared to value investing.
Value investing often appeals to investors who are persistent and willing to wait for a bargain to come along. Getting stocks at low prices increases the likelihood of earning a profit in the long run. Value investors question a market index and usually avoid popular stocks in hopes of beating the market.
Advisor Insight
Will Thomas, CFP®, CIMA®, CTFA
The Liberty Group, LLC, Washington, DC
The confusion is natural, as both are passively managed investment vehicles designed to mimic the performance of other assets.
An index fund is a type of mutual fund that tracks a particular market index: the S&P 500, Russell 2000, or MSCI EAFE (hence the name). Because there’s no original strategy, not much active management is required and so index funds have a lower cost structure than typical mutual funds.
Although they also hold a basket of assets, ETFs are more akin to equities than to mutual funds. Listed on market exchanges just like individual stocks, they are highly liquid: They can be bought and sold like stock shares throughout the trading day, with prices fluctuating constantly. ETFs can track not just an index, but an industry, a commodity, or even another fund.
What Is the Difference Between an ETF and an Index Fund?
The main difference between an ETF and an index fund is that ETFs can be traded during the day and index funds can only be traded at the set price point at the end of the trading day.
Do ETFs or Index Funds Have Better Returns?
ETFs and index funds have both performed well historically. It may be wise to check the overall costs of each and compare them before you decide where to invest your money.
Are ETFs or Index Funds Safer?
Neither an ETF nor an index fund is safer than the other because it depends on what the fund owns. Stocks will always be riskier than bonds but will usually yield higher returns on investment.
The Bottom Line
Both index mutual funds and ETFs can provide investors with broad, diversified exposure to the stock market, making them good long-term investments suitable for most investors. ETFs may be more accessible and easier to trade for retail investors because they trade like shares of stock on exchanges. They also tend to have lower fees and are more tax-efficient.
FAQs
ETFs are investment vehicles that include a mix of assets such as stocks, bonds, commodities and more. They can be traded on a market exchange, often tracking the performance of a market segment or index. Index funds are mutual funds that aim to replicate the performance of a benchmark index.
What is the difference between index fund and ETF? ›
Both are used in passive investing strategies. The biggest difference between them is that ETFs trade intraday at various prices during exchange hours and index mutual funds can be bought or sold only after the market closes each day, at a fund's net asset value.
Should I have both index fund and ETF? ›
Investing in both index funds and ETFs can be beneficial, as they offer different advantages. While there may be some overlap in the investments they hold, there can still be value in holding both.
What are the three key differences between index funds and mutual funds? ›
The three main differences are management style, investment objective and cost — and index funds are the clear winner over the long term.
What is the main advantage of index ETFs over index mutual funds? ›
ETFs tend to be more liquid, have lower net fees, and are more tax efficient than equivalent mutual funds. For those seeking a more active approach to indexing, such as smart-beta, a mutual fund may provide more expert professional management.
Why choose ETF over index fund? ›
ETFs and index mutual funds tend to be generally more tax efficient than actively managed funds. And, in general, ETFs tend to be more tax efficient than index mutual funds. You want niche exposure. Specific ETFs focused on particular industries or commodities can give you exposure to market niches.
Is the S&P 500 an ETF or index fund? ›
While an S&P 500 index fund is the most popular index fund, they also exist for different industries, countries and even investment styles. So you need to consider what exactly you want to invest in and why it might hold opportunity: Location: Consider the geographic location of the investments.
What are 2 cons to investing in index funds? ›
The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification. Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).
Is it wise to only invest in index funds? ›
Investing legend Warren Buffett has said that the average investor need only invest in a broad stock market index to be properly diversified. However, you can easily customize your fund mix if you want additional exposure to specific markets in your portfolio.
What are the pros and cons of ETFs vs index funds? ›
ETFs can trade intraday, meaning investors can move in and out of these funds like a stock. Conversely, index funds are priced only at the end of the day, making them less attractive for those looking to make short-term trades. An ETF can be passively managed, or it can be actively managed.
The main difference is that index funds are passively managed, while most other mutual funds are actively managed, which changes the way they work and the amount of fees you'll pay.
Do index funds pay dividends? ›
Dividend index funds can be mutual funds or exchange-traded funds (ETFs). Investors can select an index that includes multiple dividend-paying stocks. They generally provide steady income instead of high growth.
What are the pros and cons of index funds? ›
Index funds are a low-cost way to invest, provide better returns than most fund managers, and help investors to achieve their goals more consistently. On the other hand, many indexes put too much weight on large-cap stocks and lack the flexibility of managed funds.
Why would someone rather invest in an index fund? ›
Lower costs: Index funds typically have lower expense ratios because they are passively managed. Market representation: Index funds aim to mirror the performance of a specific index, offering broad market exposure. This is worthwhile for those looking for a diversified investment that tracks overall market trends.
What are the cons of investing in index funds? ›
Cons of Index Funds
- Less Flexibility. While your portfolio is less affected by a declining singular asset, it's not immune to the fluctuations of the larger market, including economic downturns and bear markets. ...
- Moderate Annual Returns. ...
- Fewer Opportunities for Short-Term Growth.
Because ETFs are bought and sold on the open market, the sale of shares from one investor to another does not affect the fund. The sale of ETF shares does not require the fund to liquidate its holdings or generate tax implications from capital gains, keeping costs to investors lower.
Is an ETF basically an index fund? ›
Index funds track an underlying index. Both exchange-traded funds (ETFs) and mutual funds can be index funds if their goal is to track the return of a benchmark index. ETFs and mutual funds that track an index typically have lower management fees than actively managed ETFs or mutual funds.
Why is ETF cheaper than index? ›
Because ETFs are bought and sold on the open market, the sale of shares from one investor to another does not affect the fund. The sale of ETF shares does not require the fund to liquidate its holdings or generate tax implications from capital gains, keeping costs to investors lower.
What is better a S&P 500 ETF or mutual fund? ›
The choice comes down to what you value most. If you prefer the flexibility of trading intraday and favor lower expense ratios in most instances, go with ETFs. If you worry about the impact of commissions and spreads, go with mutual funds.
