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 index funds or ETFs? ›
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 the main advantage of index ETFs over index mutual funds? ›
Key Takeaways
ETFs tend to be more liquid, have lower net fees, and are more tax efficient than equivalent mutual funds. For those seeking a more active approach to indexing, such as smart-beta, a mutual fund may provide more expert professional management.
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)
While an S&P 500 index fund is the most popular index fund, they also exist for different industries, countries and even investment styles.
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 use an index fund instead of a mutual fund? ›
The main difference is that index funds are passively managed, while most other mutual funds are actively managed, which changes the way they work and the amount of fees you'll pay.
Why index funds are better? ›
Are Index Funds Good Investments? Index funds are very popular among investors. They offer a simple, no-fuss way to gain exposure to a broad, diversified portfolio at a low cost for the investor. They are passively managed investments, and for this reason, they often have low expense costs.
Top sector ETFs
| Fund (ticker) | YTD performance | Expense ratio |
|---|
| Vanguard Information Technology ETF (VGT) | 10.8 percent | 0.10 percent |
| Financial Select Sector SPDR Fund (XLF) | 9.6 percent | 0.09 percent |
| Energy Select Sector SPDR Fund (XLE) | 9.3 percent | 0.09 percent |
| Industrial Select Sector SPDR Fund (XLI) | 7.4 percent | 0.09 percent |
Because index funds buy and sell stocks so infrequently, they rarely trigger capital gains taxes for investors. When it comes to tax efficiency, ETFs have the edge. Unlike index funds, ETFs rarely buy or sell stock for cash.
Should I convert index fund to ETF? ›
If 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.
Can an ETF go to zero? ›
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.
What happens if ETF shuts down? ›
ETFs may close due to lack of investor interest or poor returns. For investors, the easiest way to exit an ETF investment is to sell it on the open market. Liquidation of ETFs is strictly regulated; when an ETF closes, any remaining shareholders will receive a payout based on what they had invested in the ETF.
Which ETF gives the highest return? ›
Performance of ETFs
| Schemes | Latest Price | Returns in % (as on Jun 26, 2024) |
|---|
| CPSE Exchange Traded Fund | 92.91 | 111.06 |
| Kotak PSU Bank ETF | 735.92 | 81.21 |
| Nippon ETF PSU Bank BeES | 82.01 | 81.11 |
| SBI - ETF Nifty Next 50 | 750.50 | 64.38 |
32 more rowsBecause index funds buy and sell stocks so infrequently, they rarely trigger capital gains taxes for investors. When it comes to tax efficiency, ETFs have the edge. Unlike index funds, ETFs rarely buy or sell stock for cash.
Are index funds still the best way to invest? ›
Research has shown that investors are much better off with an indexed fund rather than an actively managed portfolio. Yet the belief in being able to predict short-term gains and losses persists.
Should I put most of my money in ETFs? ›
You expose your portfolio to much higher risk with sector ETFs, so you should use them sparingly, but investing 5% to 10% of your total portfolio assets may be appropriate. If you want to be highly conservative, don't use these at all.
Should I pick stocks or index funds? ›
For a conservative investor who is relatively risk averse, index funds are a better choice. This is regardless of whether they have good knowledge about individual companies and also have time to make quick calls every day, given the market realities.
