ETF vs. Index Fund: Knowing the Difference

A corporate stock is sometimes a risky investment because it can be difficult to predict how it’s going to perform—and if the stock value plummets, you’ll need a highly diversified portfolio to weather the loss. That’s why many investors choose “bundled” assets, like an exchange-traded fund (ETF) or index fund. These are low-cost, low-risk investments that provide strong and reliable returns.

Let’s compare the ETF vs. index fund. How are they similar? How are they different? And how do you know which one is right for you?

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What is an Index Fund?

An index fund is a mutual fund that’s not actively managed by an investment manager.

Here’s a quick refresher on mutual funds. A mutual fund is a pool of money that’s collected from several different investors—sometimes even dozens or hundreds of investors. Investors don’t directly own any of the stock that’s purchased by the mutual fund, but each investor receives an equal share of the profits. Mutual funds are typically managed by an investment manager who selects which securities are going to be purchased.

An index fund is a unique type of mutual fund because it’s “passively managed.” In other words, there isn’t an investment manager that’s choosing securities. All the stocks in the index fund are representative of an entire market index.

A market index tracks the performance of many different stocks within a specific industry. Here are some of the well-known market indexes on Wall Street:

• S&P 500: Tracks 500 of the largest publicly-traded companies
• Dow Jones Industrial Average: Tracks the 30 largest U.S. companies
• Bloomberg Barclays U.S. Aggregate Bond: Tracks the U.S. bond market
• Nasdaq Composite: Tracks approximately 3,000 tech companies
• Russell 2000: Tracks about 2,000 smaller U.S. companies

Let’s say that you buy into an index fund that holds stocks in the S&P 500. Should the market index see an annual gain, then your index fund will get a proportional gain—likewise if the market index sees an annual loss. Your profit will match whatever profit the market gets. And since market indexes tend to increase in value over long periods, an index fund provides a very reliable return on investment.

Know that index funds can’t outperform the market. You won’t ever see again that’s greater than what the market gains, like you can with an individual corporate stock. But many investors believe that a consistent investment is better than a high-risk, high-reward investment.

What is an ETF?

An exchange-traded fund (ETF) is essentially a basket of assets that can be traded on a market exchange. An ETF may hold several different types of securities. Here are a few of the commonly traded ETFs:

• Bond ETFs: Hold government and corporate bonds
• Industry ETFs: Hold securities within a particular industry (like technology or medicine)
• Commodity ETFs: Hold assets pertaining to commodities, like crude oil or gold

You might hear about something called an “inverse ETF.” These may be sought by seasoned traders, but know that they’re not a true type of ETF. You won’t want to prioritize them if you’re a beginning investor.

The main difference between an index fund and an ETF is that an ETF can be traded during the day on the stock market. Later on, we’ll discuss how that can benefit you (or not).

ETF vs. Index Fund: Similarities

As you might have noticed, ETFs and index funds appear to be remarkably similar: they’re both just a bundle of different securities. Here are some of the benefits of both ETFs and index funds:

• Diversification
• Low-Cost
• Long-Term Investing

They’re Good for Diversification

An ETF and an index fund are both a great way to diversify your investment portfolio.

Diversification is when you hold a variety of different assets—for example, a diverse portfolio might include several different types of stocks, bonds, and maybe even real estate holdings.

When you hold a diverse array of assets, you’re better protected if one of your investments fails. For instance, if one of the companies you’ve invested in files for bankruptcy, you’ll still have other assets generating money for you. Diversification is also a good way to earn multiple streams of revenue.

ETFs and index funds hold a variety of different securities. Just a small number of ETFs or index funds can provide you with a highly diverse portfolio.

They’re Low-Cost

Neither ETFs nor index funds are managed by investment managers, which means they’re far less costly than mutual funds.

While actively managed funds typically have expense ratios between 0.5% and 1.0%, passively managed funds—like ETFs and index funds—have an average expense ratio of about 0.2%.

Pro Tip: Actively managed ETFs do exist. Avoid them if you’re on a tighter budget.

They’re Great for Long-Term Investing

ETFs and index funds usually outperform actively managed funds over a longer period.

Actively managed funds may generate stronger returns over a short period because there’s a financial expert making decisions based on the current market conditions. But it’s highly improbable that an investment manager will consistently make decisions that will outperform the market. Mutual funds are bound to incur major losses or only minimal gains at one point or another.

If you’re a long-term investor (and especially if you’re investing in your retirement), you’ll appreciate the consistently strong returns that are generated by index funds and ETFs.

Key Differences of ETFs vs. Index Funds

The main difference between an ETF and an index fund is how each is bought and sold. ETFs are traded on an exchange, while index funds are only traded once per day after the markets close.

That might not seem like a stark difference, but it drastically affects the suitability of either investment option depending on your budget and your goals. Here are the key differences of ETFs vs. index funds:

• Liquidity
• Minimum Investment Requirements
• Expenses, Fees, and Cost of Ownership
• Taxation

Liquidity: Buying and Selling

Here’s an important investment term for you: liquidity. Liquidity refers to how difficult it is to sell an asset without affecting its value.

An ETF has far better liquidity than an index fund. As mentioned above, ETFs are traded throughout the day at a stock exchange. Like stocks and bonds, the ETF prices will fluctuate throughout the day. You can buy or sell ETFs freely, and there are no minimum purchases required.

Index funds, on the other hand, are only bought and sold at the very end of the trading day after the markets have closed.

This probably won’t make any difference for long-term investors. But it matters a great deal for those investors who want to participate in day trading.

Index funds often require you to give notice before selling your position, so it’s difficult—if not impossible—to buy or sell quickly. Also, index funds will not process trade orders until the end of the day.

Let’s say that, at 2:00 PM, you see an index fund that’s priced lower than usual. You immediately put in an order to buy into the index fund. Unfortunately, the order won’t be processed until day’s end—and by that time, the index fund is now priced higher than what you saw earlier. Day traders are unable to move quickly on index funds, and that’s why they’re not a good option for active trading. But ETFs have no such limitations.

However, it’s important to remember that none of this matters to long-term investors. ETFs are probably a less risky investing option over the long term than trading company stocks.

Minimum Investment Requirements

Most of the time, ETFs have a lower minimum investment requirement than index funds. Generally, an ETF costs only as much as buying a single share (and some sellers even offer fractional shares).

Index funds usually have investment minimums that are much higher than a single share price. Oftentimes they’re between $1,000 and $3,000.

You may be able to find online brokers that don’t have a minimum investment requirement. Many online brokers offer index funds with remarkably low minimum investments. But most of these online brokers will also offer ETFs with no commission costs, so ETFs are still the cheaper option.

Furthermore, index funds may charge a “load” fee when you purchase—basically just a commission. It’s an uncommon charge, but it’s still possible you may encounter one.

Expenses, Fees, and Cost of Ownership

Both ETFs and index funds are low-cost investments. However, ETFs typically have lower expense ratios than index funds.

So far as commissions go, you might be required to pay a flat fee every time you buy or sell an ETF (but, as mentioned earlier, many online brokers offer commission-free trading for ETFs).

An ETF may come with an additional expense called a “bid-ask spread.” The bid-ask spread is the difference between the asking price and the bidding price, and it’s commonly collected by the seller as a transaction fee for non-commission trading. Be mindful of it when you’re shopping around for an ETF and always look for the lowest possible bid-ask spread.
Index funds may also come with trading fees, but you’ll probably encounter them less often because most investors don’t buy or sell index funds on a recurrent basis. On that note, index funds are more practical if you plan on reinvesting dividends. Most index funds give you the option to automatically roll over your dividends. With an ETF, you’ll need to manually purchase additional shares.

Taxation

EFTs are generally more tax-efficient than index funds because of the way each is structured.

To get cash from an index fund, you’ll have to request that the index fund manager (whether it’s a real person or a computer program) sell your holdings. If you make a profit on the sale, then you’ll have to pay capital gains tax on what you collected—and so will every other investor in the index fund.

Shares are bought and sold every time an investor enters or leaves an index fund, and any time there’s a capital gain, every investor that’s part of the fund will need to pay capital gains tax. That means you may have to pay capital gains tax even if you haven’t sold any shares.

This happens more often with mutual funds than with index funds. But there’s no doubt that an ETF gives you greater control over buying and selling, and thus, claiming a gain or loss.

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Advantages of an ETF vs. Index Fund

ETFs are generally more cost-effective than mutual funds because they have lower expense ratios and minimum investment requirements, and they give you more control over when you can buy or sell.

However, long-term investors will probably not notice these disparities. They’ll affect day traders much more.

• ETFs are generally more cost-effective and more liquid than mutual funds (index funds)
• Break down future goals into short and long term.
• ETFs may be better for investors who want to do active trading (because of the fact they’re trading during the day on exchanges)
• With ETFs, you can take advantage of price movements that happen during the day.

ETF vs. Index Fund: Which is Right for You?

ETFs may be a better option if:

• You Want to Be an Active Trader: If you want to trade securities during market hours, an ETF is the better option—index funds can’t be traded during the day
• You’re On a Tighter Budget: Index funds require higher investment minimums, so ETFs may be optimal if you have less money to spend up-front

Index funds may be the better option if:

• You Desire Easy Maintenance: Index funds are generally much easier to manage, especially if you’re a long-term investor
• You Have Less Risk Tolerance: Index funds are considered a little safer than ETFs because they often hold more securities
• Your Broker Charges High Commissions: If your broker charges high commissions, you’ll pay more money to buy and sell ETFs

Keep in mind that, in the world of online investing, the gap between ETFs and index funds is narrowing. For many beginning investors, all that matters is the up-front cost.

Compare index funds and ETFs that you’re interested in buying. You’ll be able to find some that are roughly comparable—for example, a technology-related ETF and a technology-related index fund. See how their costs compare and make a decision based on your budget, investment goals, and risk tolerance. And you can, by the way, invest in both ETFs and index funds.

Pro Tip: ETFs and index funds are good for retirement savings, but retirement-oriented investors may still be better off investing in a 401(k) or an IRA. For retirement investors, an ETF or index fund may be a good secondary/supplemental investment option.

Summary

An index fund is a collection of securities that is financed by a pool of investors. An exchange-traded fund (ETF) is a basket of securities that’s traded between investors. When considering an ETF vs. index fund, remember both are low-cost and good for long-term investing and diversification. An ETF may be better for active traders and investors with a more limited budget. An index fund may be optimal for investors seeking an easy, safer investment.

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