Exchange-traded funds are an increasingly popular investment option because of their low costs, flexibility and tax advantages. They also give you exposure to the stock market without having to pick the stocks yourself, making them similar to index funds.
But there are also important differences. 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. Read on to learn more about the similarities and differences between an ETF and an index fund.
What Is an Index Fund?
Because an index fund is a type of mutual fund, it helps to understand what a mutual fund is. A mutual fund is essentially a pool of money collected from different investors and overseen by a professional fund manager, who puts the money into different investments. Investors don’t directly own individual stocks in the fund, though they do share in any of its profits or losses.
What separates an index fund from a traditional mutual fund is that it’s not actively managed by a financial manager. Instead, it is set up to automatically replicate the performance of a specific market index. 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 similar to an index fund in that it typically tracks an index. However, ETFs trade on an exchange like a stock, and index funds don’t. Moreover, some ETFs are actively managed and are not index-based.
Because most ETFs are not actively managed, they also tend to 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 are an especially good option for investors without a lot of capital because you can build a highly diversified portfolio without having to invest a great deal of money. And because you can trade ETFs intraday, like stocks, they also provide a good deal of liquidity.
Key Similarities Between Index Funds and ETFs
The main thing that index funds and typical ETFs have in common is that they’re both passive investment vehicles that involve tracking a market index and pooling investors’ money into a basket of securities. Unlike actively managed mutual funds, which are designed to outperform a certain benchmark index, ETFs and index mutual funds both aim to track and match the performances of certain market indexes.
Index funds and ETFs both offer exposure to a diverse range of stocks, bonds and other investments. They also tend to be cheaper than other types of investments.
Key Differences Between Index Funds and ETFs
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.
In contrast, the prices of index funds are based on the net asset value of the underlying securities. That price is determined once a day after markets close.
Other key differences include the following:
- ETFs are usually cheaper than index funds when you buy them commission-free.
- You’ll often face higher minimum investments with index funds than with ETFs, though certain fund providers, such as Fidelity Investments, have decreased their minimum investments on mutual funds.
- Index funds can be bought in dollar increments, whereas ETFs must be bought by the share like stocks.
Here’s a closer look at other differences between ETFs and index funds.
ETFs and index funds are subject to capital gains tax, both on the fund’s earnings and when shares are sold. However, ETFs can 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, which provides certain tax advantages to investors.
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, might require a minimum investment of several thousand dollars.
This minimum differs from broker to broker, but it’s not uncommon to see minimum investments of $1,000 and higher. 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 but don’t have much money, a number of funds that require a low (or no) minimum are available, such as the Fidelity ZERO Large Cap Index Fund and the Schwab S&P 500 Index Fund.
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 weighted average expense ratio for ETFs in 2019 was 0.45%, according to data from Morningstar. The average traditional index fund expense ratio was 0.06% in 2020, according to a 2021 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 might pay a brokerage commission every time they buy or sell shares. While brokerage commissions vary depending on the broker, these commissions can add up quickly.
Questions To Ask When Considering an Index Fund or ETF
Deciding whether an index fund or ETF is the better choice depends on your individual financial goals. Here are some questions to ask yourself before making a decision.
What does the index track, what’s inside, and how long has it been around?
Index funds and ETFs that track long-standing indexes such as the S&P 500 and Russell 3000 have stood the test of time, producing consistently strong returns over the years. However, many index funds and ETFs now track much more arcane segments of the market that pose a higher risk. If you are a moderate to conservative investor, your best option is to buy a fund or ETF with a proven track record.
How much will it cost to invest?
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.
Vance Cariaga contributed to the reporting for this article.
This article has been updated with additional reporting since its original publication.