Index Fund vs. ETF: An Overview
Learning investing basics includes understanding the difference between an index fund (often invested in through a mutual fund) and an exchange traded fund, or ETF. First, ETFs are considered more flexible and more convenient than most mutual 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 hurdles than mutual funds. By purchasing ETFs, investors can avoid the special accounts and documentation required for mutual, for example. While similar in many ways, here we discuss the differences between an index fund vs. ETF.
- Mutual funds are pooled investment vehicles managed by a money management professional.
- Exchange traded funds ( ETFs) represent baskets of securities 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 are lower cost and more tax-efficient than similar mutual funds.
Index Mutual Funds
Index funds are funds that represent a theoretical segment of the market and are 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. When you do so, you are utilizing a form of passive investing that sets rules by which stocks are included, 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, and index funds have lower expenses and fees than funds that are actively managed.
People interested in investing in an index fund can generally do so through a mutual fund designed to mimic the index.
Exchange-Traded Funds (ETFs)
ETFs are baskets of assets traded like securities. They can be bought and sold on an open exchange, just like regular stocks, as opposed to mutual funds, which are only priced at the end of the day.
Other differences between mutual funds and ETFs relate to the costs associated with each one. Typically, there are 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, on the other hand, tend to prefer ETFs.
Compared to value investing, index fund investing is considered by financial experts as a rather passive investment strategy. Both of these types of investments 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.
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). 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.
What Is the Difference Between an ETF vs. Index Fund?
The main difference between an ETF and an index fund is ETFs can be traded (bought and sold) 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 historically have both performed well. 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, as it depends on what the fund owns. Stocks will always be risker 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 easy to trade for retail investors as they trade like shares of stock on exchanges. They also tend to have lower fees and are more tax-efficient, on average.