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Index Funds vs. ETFs: What You Need to Know

Index funds and exchange-traded funds (ETFs) similarly earn returns through a series of investments. But how they trade and what they cost varies. However, there are some ETFs that are also index funds and vice versa. That means the subtle differences between each of these investment types make them specifically better options for certain investors over others. If you have questions about how to build your portfolio, speak with a local financial advisor.

What Is an Index Fund?

An index fund is a type of mutual fund that invests in a collection of securities which 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 in that index. Although most index funds are mutual funds, they can also be an ETF. 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 investors receive dividends, they usually reinvest them. 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.

What Is an ETF?

An ETF, or exchange-traded fund, is a collection of investments that track specific areas of the market. In other words, they are comprised of multiple single securities that form a larger group, with each being in the same general area of the market (technology, aviation, agriculture etc.). For example, an ETF might track a popular index, like the S&P 500.

Mutual funds and some other investment funds have to be bought into, but ETFs can be traded as easily as stocks. That makes them infinitely more accessible for smaller investors, as mutual funds often require some kind of minimum investment to get in.

Although they trade like them, ETFs are much less risky than individual stocks. This is because they bet on an entire market to succeed rather than a single company. On the other hand, stocks have the potential for higher growth than ETFs.

What’s the Difference Between Index Funds and ETFs?

Index Funds vs. ETFs: What You Need to Know

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 when you please during trading hours. By comparison, mutual funds are priced at the end of the day, and are often more exclusive. 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 focus 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 work like 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.

Independently from your choice, make sure to compare the expense ratio for each before investing. This is a yearly operating expense, and shareholders of mutual funds and ETFs must pay them based on a percentage of the fund’s average net assets. You will be charged these ongoing costs for the duration of your investment and they will reduce your return.

Choosing Between Index Mutual Funds and Index ETFs

If you have already decided that you want an index fund, then you’ll need to pick 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 between $5 and $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, though, as some ETFs are actively selected and managed. However, most popular funds operate this way.

Bottom Line

Index Funds vs. ETFs: What You Need to Know

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 hands-off individuals, 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 prefer to buy and sell frequently, then you’ll need to opt for an ETF. 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 route for you. Luckily, finding the right financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three advisors in your area in five minutes. 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.

Photo credit: ©iStock.com/DragonImages, ©iStock.com/ ipopba, ©iStock.com/joste_dj

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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