When you’re new to investing, figuring out which assets are the best fit for your portfolio can be tricky. For rookie investors, many recommend starting off investing in an index fund or an exchange-traded fund (ETF), as these provides diversification without requiring in-depth knowledge of the market. However, it’s important to understand the distinctions and similarities between these two investment products, as many investors frequently use the two terms interchangeably.
It’s easy to see why. Many ETFs are themselves types of index funds, leading to some confusion. However, not all ETFs are index funds, and not all index funds are ETFs. Understanding how they can differ can help you to invest with a clearer purpose in mind.
How Index Funds Work
An index fund is a collection of securities that aims to track a specific market index or the market as a whole. For example, an index fund that tracks the S&P 500 would include stock holdings from all of the companies included in that index. Index funds can be mutual funds or ETFs; both of these are “baskets” of securities, but they differ in some key ways. (More on that in a bit.)
What’s great about index funds is that they allow you to get a broad exposure to the market as a whole. Because you’re investing in an entire index versus individual stocks, index funds don’t need to be actively managed by a fund manager. That’s a boon for investors since it typically translates to a lower expense ratio. That means you won’t have as many fees eating into your returns.
The lack of active management means that there’s less turnover. In other words, investors typically don’t buy and sell index funds as frequently as individual stocks. When dividends are paid out, they’re typically reinvested. Dividends are considered income, so you’ll pay taxes for them. But you won’t have to worry about paying capital gains tax until you sell your index funds.
Comparing Index Funds to ETFs
Comparing index funds to ETFs is a difficult exercise, because in many cases, the two overlap.
Broadly speaking, there are two ways to invest in “baskets” of securities: Mutual funds and ETFs. The two are similar in many ways, and different in a few. The differences mainly regard how they’re traded. ETFs trade like stocks – you buy individual shares during regular trading hours. To buy into a mutual fund, you don’t need to buy a whole share, but you might run into a minimum investment amount.
Within the world of mutual funds and ETFs are a whole range of investing approaches. Some are focused on emerging markets and smaller companies, while others trade in larger, more established companies. Some, too, are more likely to trade actively, while others take a more passive approach. At the extreme end of the “passive” end of the spectrum are index funds. There are index funds that are set up as mutual funds, and index funds set up as ETFs. (Generally speaking, ETFs are more likely than mutual funds to be index funds, but there are plenty of index mutual funds, and plenty of non-index ETFs.)
So rather than ask whether to invest in ETFs or index funds, you should be asking two questions: Do you want to invest in an entire sector of the market, or do you want a more strategic and active approach? And having decided that, do you want your fund to be a mutual fund or an ETF?
Index ETFs vs. Index Mutual Funds
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 are traded on an exchange throughout the trading day, just like stocks. ETFs are highly liquid (meaning that you can trade them easily) and their prices go up and down over the course of a single day. 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. If you’re using a discount broker, these fees may be $5 to $15 per trade, and they can add up quickly if you’re trading frequently. Still, many brokers offer a range of ETFs that are commission-free.
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.
Which Is Better for Beginning Investors?
If you’re a new investor, the question of whether you should buy ETFs or index mutual funds ultimately comes down to how much money you have to invest and your trading preferences. The minimum cost to start investing in index mutual funds is typically higher than for an ETF.
If you’re looking to buy and sell shares multiple times per day, then you’ll want to opt for ETFs. However, don’t forget that commission fees can add up and effectively erase any gains that you make.
Regardless of which you choose, both products help you achieve a diverse portfolio without as much work as individual stock selection.
The Bottom Line
Index funds and exchange-traded funds have a lot in common, but if you’re a new investor, it’s a good idea to do your research in order to understand the differences between the two. 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.
Tips for Investing Responsibly
- If your investments pay off, you may owe the capital gains tax. Figure out how much you’ll pay when you sell your stocks with our capital gains tax calculator.
- Having trouble deciding the best way to approach your investments? A financial advisor can be a big help. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
Photo credit: ©iStock.com/DragonImages, ©iStock.com/ Vladimir Cetinski, ©iStock.com/joste_dj