ETF vs. Index Fund: What Is the Best Option for You?

Learn about the differences between ETFs and index funds.

Exchange-traded funds have become popular among investors -- but if you haven't invested in them yourself, you might be wondering how they differ from index funds.

One way the two differ is that while investors can trade ETFs throughout the day, you can only trade index funds at the price set after market closing.

On the other hand, they are alike in that both index funds and most ETFs track an index, so you usually know exactly what's inside the investment.

Read on to learn more about the similarities and differences between an ETF and an index fund.

What Are Index Funds?

An index fund attempts to replicate the performance of an index, a group of stocks that represent a portion or all of the stock market. For example, the Vanguard 500 Index Fund attempts to replicate the S&P 500.

When you invest in an index fund, you invest in all of the investments in an index, which helps diversify your portfolio. Because index fund managers buy and hold rather than trade frequently, the funds are cheaper to manage.

What Is an ETF?

An ETF is a security that typically tracks an index, similar to an index fund, but ETFs trade on an exchange like a stock. Note that some ETFs, however, are actively managed and are not index-based.

Because most ETFs are not actively managed, they also usually have low fees. Unless a component of the underlying index has changed, the fund manager doesn't need to buy or sell investments frequently.

ETFs work well for investors who want to diversify their portfolio, but don't want to be restricted to trading at the end of the day. The ability to trade shares of an ETF whenever the stock market is open helps increase the investment's liquidity.

Index Funds vs. ETFs: Key Similarities and Differences

Index funds and ETFs both offer a diversified pool of assets, giving investors access to stocks, bonds and potentially other markets.

In both an index fund and an index-based ETF, the investor has a straightforward strategy that tracks the breadth of the market by buying shares in a low-cost index.

Price and Trading

The biggest difference between index funds and ETFs is the frequency with which they are priced and traded.

Because ETFs trade like stocks, the price depends on supply and demand for the security. Buyers can take advantage of pricing dips during the day to buy at more favorable prices. Similarly, if an investor thinks an ETF will gain in value, they can buy early to take advantage.

Index funds' prices are based on the net asset value of the underlying securities. That price is determined once a day after markets close.

Taxes

ETFs and index funds are subject to capital gains tax, both on the fund's earnings and when shares are sold. However, ETFs may have the upper hand.

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.

Index funds, like other mutual funds, could generate a slightly higher tax bill due to how actively they are managed. Each time an underlying security is sold for profit, that creates a taxable event.

Minimum Investment

The minimum investment needed for an ETF is the price of a single share. Some brokers, like Betterment and Fidelity, even let you invest in fractional shares of an ETF.

Index funds, on the other hand, may require you to invest a minimum to buy into them.

This minimum differs from broker to broker, but it's not uncommon to see minimum investments upward of $1,000. For example, the Vanguard 500 Index Fund Admiral Shares requires a minimum investment of $3,000.

GOOD TO KNOW

If you're looking to invest in an index fund, there are a number of investment funds available that require a low (or no) minimum.

Dividends

Dividends can be an important component of any investment. Because ETFs are traded like stocks, dividends and interest earnings from the underlying securities are distributed to shareholders at the end of each quarter. However, not all index funds pay dividends.

Fees and Expenses

The average ETF carries an expense ratio of 0.44%, which means the fund will cost you $4.40 in annual fees for every $1,000 you invest, according to the Wall Street Journal.

The average traditional index fund expense ratio was 0.08% in 2018, according to a 2019 study from the Investment Company Institute.

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 bonds 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.

When trading ETFs, buyers may pay a brokerage commission every time they buy or sell shares. While brokerage commissions vary depending on the broker, those commissions can add up quickly.

ADVICE

To save money on buying index funds and ETFs, use an online brokerage that doesn't charge a commission, such as:

Questions To Ask When Considering an Index Fund or ETF

Whether an index fund or ETF is better ultimately depends on your goals and the particular options you're considering. Here are some questions to ask yourself to decide.

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 funds and ETF creators are stretching the definition of indexing. Some have created new indexes that track arcane segments of the market.

How much will it cost to invest?

An expense ratio tells you how much an ETF costs. The amount is skimmed from your account and goes toward 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.

ASSESS YOUR FINANCIAL HEALTH

Index funds and ETFs can suit a variety of investors, but your investments are among many factors that impact your overall financial health. Consider working with a financial advisor to help you find the best option for you.

This article has been updated with additional reporting since its original publication.

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About the Author

Kyle has been helping individuals and families accumulate and preserve wealth for retirement for nearly 20 years. He is an Investment Advisor Representative, owner of Secure Wealth Strategies, Inc. and is also life insurance licensed.

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