Index funds and exchange-traded funds (ETFs) similarly earn returns based on a series of indexed investments, but how they’re traded and what they cost varies. Both ETFs and index funds are each popular choices for new investors, though. There are even some ETFs that are also index funds and vice versa. That means the subtle differences between each of these investments make them specifically better options for certain investors over others. If you have questions about how to build your portfolio, a financial advisor in your area can help.
What Are Index Funds?
An index fund is a type of mutual fund that invests in a collection of securities that aims to track a specific market index or a market as a whole. For example, an index fund that tracks the S&P 500 would include stock holdings from all companies included in that index. Although most index funds are mutual funds, they can also come in an ETF variation. Conversely, an ETF can also be an index fund.
What’s enticing about index funds is that they allow you to get broad exposure to a specific market. Because you’re investing in an index of related securities versus individual stocks, index funds don’t require the traditional active management of a fund manager. That can be a major plus for investors, since this shift leads to lower expense ratios. As a result, you won’t have as many fees eating into your returns.
Additionally, the lack of active management means there’s less turnover within the fund. In other words, investors typically don’t buy and sell index funds as frequently as individual securities, like stocks and bonds. However, when dividends are paid out, they are usually reinvested. Because dividends are technically a form of income, you’ll pay taxes on them. The capital gains tax won’t come into play until you sell your index fund shares, though.
Comparing Index Funds and ETFs
In general, index funds and ETFs have many overlapping features. Let’s start by looking at mutual funds and ETFs: the two main ways to invest in a basket of securities. ETFs trade on the market like stocks. As a result, you can buy and sell shares as you please during trading hours. Mutual funds are often more exclusive. More specifically, they don’t require you to buy shares, but they can call for a minimum investment.
Between mutual funds and ETFs, there are a whole range of investment approaches. Some are focused on emerging markets and small-cap companies. Others trade in larger, more established companies. There also exists a variation between actively managed and passively managed funds. At the extreme end of the latter, you’ll find index funds.
Furthermore, there are index funds that are set up as mutual funds, while others operate like a typical ETF. Generally speaking, ETFs are more likely than mutual funds to be index funds, but there are plenty of both across the current investment market.
Because of the aforementioned overlap between ETFs and index funds, it can be hard to differentiate between them. So rather than wonder whether you should invest in an ETF or an index fund, try asking the following: Do you want to invest in an entire sector of the market, or do you want a more strategic and active approach?
By deciding that you’d rather your investments be managed more actively, you can then begin looking for more mutual fund-centric index funds. On the other hand, if you’re more interested in capturing the benefits of a market-based investment, a non-mutual fund ETF or index is the better choice.
Index Mutual Funds and Index ETFs
If you have already decided you want an index fund, then you’ll need to decide between index-tracking ETFs and index-tracking mutual funds.
Unlike index mutual funds, ETFs trade on an exchange throughout the trading day. ETFs are highly liquid (meaning you can trade them easily) and their prices can go up and down over the course of a day. On the other hand, mutual funds only trade once per day after the market has closed. They also carry many of the same benefits, like fewer taxable distributions and lower expense ratios.
On the other hand, investing in ETFs involves paying a commission fee to a broker every time you make a trade. Even if you’re using a discount broker, these fees may be $5 to $15 per trade, though they can add up quickly. Still, many brokers offer a range of ETFs that are commission-free, such as Charles Schwab and TD Ameritrade.
Like index mutual funds, ETFs are typically passively managed, as they are attempting to match some sort of index benchmark rather than outperform it. This isn’t always the case — some ETFs are actively selected and managed — but it is for the most popular funds.
Index funds and exchange-traded funds have plenty in common. If you’re a new investor, it’s a good idea to do your research before you lay any money down. While index funds may be better for individuals who prefer a hands-off approach, some of them come with higher entry costs and fees.
Investing in an ETF offers lower expense ratios and the potential for more active trading. However, that potential also comes with commission fees. Even still, if you’d prefer to have the option to buy and sell multiple shares a day, then you’ll need to opt for ETFs. But regardless of whether you choose an ETF or an index fund, they’ll both help you achieve a diverse portfolio without as much work as individual stock selection.
Tips for Investing Responsibly
- Having trouble deciding the best way to approach your investments? A financial advisor can help you determine the best steps for you. Luckily, finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with advisors in your area in 5 minutes. If you’re ready to be matched with suitable advisors, get started now.
- If your investments pay off, you may owe taxes on the returns you earn. In the eyes of the IRS, this tax is called the capital gains tax. Figure out how much you’ll pay when you sell your investments with SmartAsset’s capital gains tax calculator.
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