What Is the Difference Between an Index Fund and an ETF?

what are exchange traded funds

Exchange traded funds have become popular among investors, but how do they differ from crowd-pleasing index funds?

Index funds and ETFs offer a diversified pool of assets, giving investors access to stocks, bonds and potentially other markets. In both an index fund and an ETF, the investor has a straightforward strategy that tracks the breadth of the market by buying shares in a low-cost index. Today you can purchase index funds and ETFs that aim to replicate the Standard & Poor’s 500 index of blue chip stocks, in emerging markets, real estate, small caps, commodities and more.

Keep Reading: How to Start Investing With Less Than $500

One of the great things about index funds and ETFs is they are open books. Because they track an index, you usually know exactly what’s inside the investment.

What Are Index Funds?

An index fund attempts to replicate the performance of a given index of stocks. That can include bonds or even a narrow subset such as small-cap biotech companies. The most popular index among investors is the S&P 500. Since an index fund owns all of the investments in an index, there is no picking winners and losers. Because index fund managers buy and hold rather than trade frequently, the funds are cheaper to manage.

More investors today own index funds. Jordan Wathen at The Motley Fool reported that $1 in every $5 that is invested in stock funds is in an index fund, about double the investment volume in index funds from the year 2000.

What Is an ETF?

An ETF is a security that tracks different indexes similar to an index fund, but ETFs trade on an exchange like a stock. ETFs, which have grown quickly in popularity, also have low fees because they’re not actively managed. Typically, the fund manager doesn’t need to buy and sell frequently unless a component of the underlying index has changed.

ETFs work well for investors who want very focused exposure to a particular industry or asset class at a reasonable cost without having to research specific securities. They’re useful as buy-and-hold investments.

Index Funds Vs. ETFs: Key Similarities and Differences

The biggest difference between index funds and ETFs is the frequency with which they are priced and traded. Index mutual funds are, after all, mutual funds, and as such, they are priced once a day after markets close. ETFs are priced throughout the day and can be bought or sold when the markets open. Index funds are priced based on the net asset value of the underlying securities, whereas the price of an ETF depends on supply and demand for the security.

The same tax rules apply to ETFs and index funds; however, ETFs might lessen the tax impact in a portfolio through a process called in-kind redemptions. When redemptions occur from an ETF portfolio, they tend to be done in securities rather than cash, and that can provide some tax advantages to investors.

Since ETFs trade like stocks, buyers must pay a brokerage commission every time they buy or sell shares. Online brokerage commissions differ depending on the broker. Those commissions add up quickly. ETFs are great for lump-sum investors, but advisors recommend a traditional index fund if you’re buying a small amount at a time.

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Dividends can be an important component of any investment. Because ETFs are traded like stocks, dividends and interest from the underlying security are distributed to shareholders at the end of each quarter. Index funds, on the other hand, reinvest their dividends or interest income immediately.

Corporate Governance

The Motley Fool’s Wathen called index funds excellent products in response to warnings about their rapid rise by Charlie Munger, Warren Buffett’s right-hand man at Berkshire Hathaway. But Wathen added this: “As they grow, index funds will need to be kept in check. As you think about which funds you wish to invest in, look first at fees, but don’t ignore funds’ form N-PX filings, which detail just how ‘activist’ or ‘passive’ each fund is when it comes to voting on corporate matters on your behalf. We all lose when fund companies don’t take an active role in corporate governance.”

To put index funds’ influence in perspective, let’s look at Apple, the single largest company in the world by market capitalization. Its top three institutional investors are prominent index fund managers Vanguard, State Street and BlackRock. Combined, these three companies control 12 percent of its shares and, naturally, 12 percent of its proxy votes. That’s a lot of power to put in so few hands.

The largest funds don’t take an aggressive stance with their proxy votes, which would be a conflict of interest, some say. Fund managers have a fiduciary responsibility to their investors, meaning they must put their clients’ financial interests before their own.

Questions to Ask When Considering an Index Fund or ETF

What does the index track, what’s inside and how long has it been around?  While index funds and ETFs that track long-standing indexes such as the S&P 500 and Russell 3000 have stood the test of time, many index fund and ETF creators are stretching the definition of indexing. Some have created new indexes that track arcane segments of the market.

Consider your costs before investing. An expense ratio tells you how much an ETF costs. The amount is skimmed from your account and goes towards paying a fund’s total annual expenses. Remember, the expense ratio doesn’t include the brokerage commissions you pay to buy and sell ETF shares.

Fees and Expenses

The average ETF carries an expense ratio of 0.44 percent, which means the fund will cost you $4.40 in annual fees for every $1,000 you invest. The average traditional index fund costs 0.74 percent, according to Morningstar Investment Research.

If you’re thinking about investing in a target-date retirement fund that invests in ETFs, find out if it will charge an extra management fee. Target-date funds invest in a combination of stocks and bond funds whose mix becomes gradually more conservative as the investor reaches retirement age. You might be better off in a target-date fund that invests in regular index funds and doesn’t charge this extra fee.

Your best bet for buying index funds and ETFs is through an online brokerage like E*Trade, Charles Schwab, Vanguard or Fidelity that charges low commissions.