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Index Funds vs. ETFs

While they both track the value of a stock index, index funds and exchange traded funds (ETFs) can take slightly different routes to do that. Both can also track markets outside of standard equity markets like precious metals, commodities like wheat, or even cryptocurrencies. Much to the confusion of new investors, the two terms are sometimes used interchangeably, which isn’t always accurate, but speaks to their similarities.

Index funds and ETFs have grown in popularity due to their simple-to-understand goals and straightforward approach to investing. Both investment vehicles are also funds, meaning they own a basket of stocks, bonds, etc., and investors buy shares of the funds rather than directly investing in the underlying stock or asset group. There are, however, differences in how the two types of funds are traded, differences in their expense structures, and some differences in their tax treatment, which can affect performance.

What is an index fund?

An index fund is a mutual fund that’s designed to mimic a benchmark index. Unlike an actively managed mutual fund that has a management team that picks stocks to buy or sell based on the stated goals of the fund, an index fund works more like a mirror of the market or a smaller part of it, like an index.

A specialized mutual fund, an index fund is purchased through the mutual fund company or through an intermediary, such as a broker.

Vanguard started the index fund craze in the mid-1970’s with the first index fund designed to mirror the S&P 500, now called the Vanguard 500 Index Fund, one of the best-known mutual funds in the market. The fund began with a mere $11 million invested. Index funds, now available through a stunning number of mutual fund companies, make up an estimated 20% of all mutual funds.

What is an ETF?

An exchange traded fund (ETF) can be traded like a stock. The fund includes stocks, bonds, or other assets that represent the fund’s stated investment goal and investors can buy shares of the fund through common retail brokerages, including discount online brokerages.

The structure provides both liquidity (usually) and easy access because investors don’t need to buy through the mutual fund company or an intermediary, like a financial planner or a full-service broker. Investors should be aware, however, that thinly-traded or highly-specialized ETFs can be volatile and can have large spreads between bid and ask prices.

Many exchange traded funds are index funds in spirit because they track an index, such as the S&P 500, the NASDAQ, the Dow Jones Industrial Average, or a subset within the market. Highly specialized ETFs are becoming much more common as well, including gold, energy, and even marijuana and cryptocurrency ETFs. If a market is new and hot, be on the lookout. An ETF is sure to follow, providing an easy way for investors to gain fast exposure to new tech trends or markets that are being moved based on legislative changes.

The ETF market has grown into thousands of exchange traded funds, some of which are simple index funds and others that have very specialized goals, such as tracking the volatility index (VIX), tracking treasury bills, or the mortgage market. As the ETF market continues to evolve, investors can expect an ETF for nearly any specialized market.

Similarities between index funds and ETFs

The often similar goals for ETFs and index funds lead the two terms to be used interchangeably. The comparison is usually fair, with the two investment options sharing much in common.

Index funds and ETFs both buy a basket of stocks or underlying assets

Investors aren’t investing directly in companies or individual stocks when purchasing index funds or ETFs. Instead, when buying an index fund or ETF, you are buying shares in the fund itself, while the fund buys shares of stock or other assets that help the fund realize its stated investment goal.

Index funds and ETFs both track an index or a market

Individual stock purchases are bets for (or against) individual companies. Index funds and ETFs provide a broader investment, although still well-focused. Mutual funds run the gamut from focused funds to actively managed funds that can include stocks in multiple sectors, as well as other assets, becoming so diversified that it’s difficult to understand what drives the value of the shares. Index funds and ETFs forgo the shotgun approach, instead choosing a more targeted investment goal with the simpler aspiration of tracking a part of the market or a type of asset.

Differences between index funds and ETFs

While index funds and ETFs have similarities and often serve the same investment goal (again, tracking an index) there are some notable differences between the two options. Most significantly, the way in which index funds and ETFs are purchased differs and each has a unique cost structure, which can affect investment returns in the short- or long-term.

ETFs and index funds are purchased using different methods

Index funds are purchased through a mutual fund company, or a broker or financial planner. It’s worth noting that many online brokers do provide access to mutual funds through a number of mutual fund companies. ETFs are more readily available because they are traded on stock exchanges, providing easy access to anyone with a brokerage account. Similarly, exiting a position on an ETF is just as easy. ETF shares are sold into the open market on an exchange. Because the money is returned to a brokerage account, investors are free to move the settled funds into any other equity, ETF, or mutual fund available through their broker.

ETFs and index funds have different internal expense structures

Index funds must rebalance daily, which creates transaction expenses and adds costs due to the bid/ask spreads on the securities bought or sold in rebalancing. ETFs can sidestep this expense in most cases by using a creation/redemption process to increase or decrease the number of shares in response to demand. Both ETFs and index funds have management fees and transaction fees that should be compared when choosing between an ETF and an index fund that track the same index.

Index funds and ETFs have different pricing mechanisms, with the price for index funds set once per day and ETFs changing price throughout the day using a creation/redemption mechanism to help match ETF share pricing to the Net Asset Value (NAV) of the fund’s shares. For long-term investors, this intraday pricing difference between index funds and ETFs won’t significantly affect investment performance unless there’s a big market move on the day the shares in the fund are sold.

Dividends are handled differently between ETF and index funds as well. An index fund invests dividends as they are distributed by the equities within the fund. ETFs, with their trust structure, wait until the end of the quarter to invest dividends, possibly affecting gains.

Final thoughts

Index funds and ETFs create an easy way to gain exposure to a sector of the market, to invest in an emerging technology, or to invest in foreign markets, with other investment areas seemingly only limited by the imagination of fund companies.

Staying with broad index funds or ETFs, such as those that track the S&P 500, historically provides better returns than most actively managed mutual funds or investing in individual stocks. Index investing that uses broad indexes, much like dollar cost averaging, allows the market to work its long-term-trend magic without trying to guess its next move. More narrowly-focused index funds and ETFs can be a grand slam or a strikeout — or something in between — similar to trading individual stocks.

Assuming similar fees, an index fund can provide more efficient gains over time because dividends are reinvested immediately. ETFs, however, allow traders or investors to be more nimble. Trades are settled at the ETF share price at the time of the trade. Index fund trades settle at the end-of-day sale price. Which to choose is a question of fees and whether you want to remain nimble or are a buy-and-hold investor.