Index Fund vs. ETF: What's the Difference?

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.

Key Takeaways

  • Mutual funds are pooled investment vehicles managed by a money management professional.
  • Exchange trade funds, or ETFs, represent baskets of securities traded on an exchange like stocks.
  • ETFs can be bought or sold at any time, whereas mutual funds are only priced at the end of the day.
  • In general, 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. This can be large companies, small companies, or companies separated by industry, among many options. It is a passive form of investing that sets rules by which stocks are included, then tracks the stocks without trying to beat them. Index funds are not investable.

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 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.

What Do the Experts Say?

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). 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.