Learning investing basics includes understanding the difference between an index fund and an exchange-traded fund, or ETF. First, ETFs are considered more flexible and more convenient than index funds. ETFs can be traded more easily than index funds and traditional mutual funds, similar to how common stocks are traded on a stock exchange. In addition, investors can also buy ETFs in smaller sizes and with fewer hassles than index funds. By purchasing ETFs, investors can avoid the special accounts and documentation required for index funds, for example.

Other differences between index funds and ETFs relate to the costs associated with each one. Typically, there are no shareholder transaction costs for index funds. Costs such as taxation and management fees, however, are lower for ETFs. Most passive retail investors choose index funds over ETFs based on cost comparisons between the two. Passive institutional investors, on the other hand, tend to prefer ETFs. Investors can purchase ETFs that represent a particular index such as the Wilshire 5000 Total Market Index.

Compared to value investing, index fund investing is considered by financial experts as a rather passive investment strategy. Both of these types of investing are considered to be conservative, long-term strategies. 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.

The Advisor Insight

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). Since 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.

Will Thomas
The Liberty Group, LLC
Washington, DC