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. Because of this, you want to make a choice that better aligns with your long and short-term goals. Some people are concerned about how much they can profit right now, but others are willing to invest for long periods of time.

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.

How Do Index Funds Work?

Index funds are designed to mimic the performance of a specific market index. They achieve this by holding a diverse portfolio of the same stocks or securities in the index. This allows investors to gain broad market exposure. Index funds usually have lower management fees than actively managed funds. This makes them a cost-effective option for investors aiming for long-term growth. Their simplicity and efficiency contribute to their popularity among both novice and experienced investors.

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.

How Do ETFs work?

Exchange-Traded Funds (ETFs) are investment funds traded on stock exchanges. They allow investors to pool their money for buying various assets like stocks, bonds, or commodities. This provides access to different sectors or strategies without buying individual securities. A key feature of ETFs is their high liquidity. Investors can buy or sell shares during the trading day at market prices. This differs from traditional mutual funds, which are priced only at the end of the day. ETFs generally have lower expense ratios than mutual funds, making them cost-effective. They are also tax-efficient, which helps reduce capital gains taxes. By tracking different indices or sectors, ETFs make it easy to diversify portfolios while allowing open market trading. Overall, ETFs are a flexible and efficient investment choice.

Index Funds vs. ETFs: Key Similarities

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.

Investing in a Diverse Basket of 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.

Tracking Market Indices for Investment

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.

Index Funds vs. ETFs: Key Differences

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.

Different Purchasing 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.

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.

Trading Strategies

ETFs are traded like stocks on a stock exchange and their prices can change throughout the trading day. Therefore, the price at which you purchase an ETF may vary from the prices paid by other investors.

Mutual funds are typically purchased directly from investment companies rather than from other investors on an exchange. Orders are executed once per day, ensuring that all investors who invest on the same day receive the same price.

Index Funds vs. ETFs: Liquidity

Liquidity matters when comparing index funds and ETFs. Index funds allow easy share redemption with the Asset Management Company (AMC) at any time. ETFs trade on stock exchanges. Their liquidity relies on market buyers and can change with market conditions. During market volatility or low trading volumes, ETFs may face liquidity risks. This can result in larger bid-ask spreads and difficulties in trading at desired prices. Market makers support ETF liquidity, but their role can diminish in uncertain times. High trading volumes can decrease liquidity risks for ETFs. Many trades indicate strong interest, which helps investors buy and sell more easily. Therefore, investors should watch trading volume when considering ETFs. In contrast, index funds provide more consistent liquidity and stable redemption.

Index Funds vs. ETFs: Price

ETFs and index funds differ in several ways. ETFs trade throughout the day at market prices. These prices can be different from their net asset value (NAV), creating a bid-ask spread. This spread can add costs when buying or selling shares. In contrast, index funds are traded based on their NAV at the end of the day. This means investors know the exact price for transactions, avoiding spread costs. Investors often prefer ETFs for their liquidity and ability to trade anytime. Index funds are typically chosen by long-term investors who want a straightforward process without daily price changes. It’s also essential to consider commission fees. Some brokers offer commission-free ETFs, while index funds may have higher expense ratios. Ultimately, your choice depends on your investment strategy, need for liquidity, and costs.

Index Funds vs. ETFs: Where are Your Investments Going?

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.

Index Funds and ETFs, Which is Better?

Index funds and ETFs are designed to mirror the performance of a specific index, but they have key differences in trading flexibility, tax efficiency, and expense ratios, which affect their appropriateness for different investors.

Index funds are ideal for long-term, passive investors who prefer a "buy and hold" approach. These funds are typically acquired directly from the fund company, allowing investors to buy or sell only at the end of the trading day, which may not be suitable for those who trade frequently.

ETFs provide more trading flexibility because they can be bought or sold at any time during the trading day on an exchange. This feature makes them attractive to active traders looking to take advantage of market fluctuations.

ETFs are often more tax-efficient because of their structure that allows for in-kind redemptions, which can help minimize capital gains distributions. Moreover, ETFs usually have lower expense ratios compared to index funds, making them more attractive.

The decision between index funds and ETFs should reflect an investor's objectives, whether they are focused on active trading or a long-term investment strategy.

Frequently Asked Questions