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
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.
Is it better to invest in ETF or 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.
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.
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 are three disadvantages to owning an ETF over a mutual fund? ›
Disadvantages of ETFs
- Trading fees. Although ETFs are generally cheaper than other lower-risk investment options (such as mutual funds) they are not free. ...
- Operating expenses. ...
- Low trading volume. ...
- Tracking errors. ...
- The possibility of less diversification. ...
- Hidden risks. ...
- Lack of liquidity. ...
- Capital gains distributions.
Disadvantages of Index Investing
- Lack of downside protection: There is no floor to losses.
- No choice in the index fund's composition: Cannot add or remove any holdings.
- Can't beat the market: Can only achieve market returns (generally)
ETFs are generally more tax efficient than mutual funds. While you will pay capital gains taxes on any gains you realize when you sell shares of an index fund or an ETF, you do not pay taxes when the holdings in the ETF portfolio are adjusted by managers.
What is the best ETF to buy right now? ›
The best ETFs to buy now
| Exchange-traded fund (ticker) | Assets under management | Expenses |
|---|
| Vanguard 500 Index ETF (VOO) | $432.2 billion | 0.03% |
| Vanguard Dividend Appreciation ETF (VIG) | $76.5 billion | 0.06% |
| Vanguard U.S. Quality Factor ETF (VFQY) | $333.3 million | 0.13% |
| SPDR Gold MiniShares (GLDM) | $7.4 billion | 0.10% |
1 more rowIf you're paying fees for a fund with a high expense ratio or paying too much in taxes each year because of undesired capital gains distributions, switching to ETFs is likely the right choice. If your current investment is in an indexed mutual fund, you can usually find an ETF that accomplishes the same thing.
What is the best S&P 500 index fund? ›
What's the best S&P 500 index fund?
| Index fund | Minimum investment | Expense ratio |
|---|
| Vanguard 500 Index Fund - Admiral Shares (VFIAX) | $3,000.00 | 0.04%. |
| Schwab S&P 500 Index Fund (SWPPX) | No minimum. | 0.02%. |
| Fidelity 500 Index Fund (FXAIX) | No minimum. | 0.015%. |
| Fidelity Zero Large Cap Index (FNILX) | No minimum. | 0.0%. |
1 more rowMay 31, 2024
For most standard, unleveraged ETFs that track an index, the maximum you can theoretically lose is the amount you invested, driving your investment value to zero. However, it's rare for broad-market ETFs to go to zero unless the entire market or sector it tracks collapses entirely.
Which ETF gives the highest return? ›
Best ETFs in India for April 2024
- CPSE ETF. 96.76%
- BHARAT 22 ETF. 68.87%
- Nippon India ETF Nifty Next 50 Junior BeES. 54.76%
- SBI Nifty 50 ETF.
Market risk
The single biggest risk in ETFs is market risk. Like a mutual fund or a closed-end fund, ETFs are only an investment vehicle—a wrapper for their underlying investment. So if you buy an S&P 500 ETF and the S&P 500 goes down 50%, nothing about how cheap, tax efficient, or transparent an ETF is will help you.
Are index funds still the best way to invest? ›
For most investors looking for a cost-effective, easy way to track market returns, index funds are absolutely worth considering. However, it's important to understand the benefits and risks of index funds before incorporating them into your investing strategy.
Why choose an ETF over a mutual fund? ›
ETFs have several advantages for investors considering this vehicle. The 4 most prominent advantages are trading flexibility, portfolio diversification and risk management, lower costs versus like mutual funds, and potential tax benefits.
Why index funds are better? ›
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.
