What are the similarities between ETFs and index funds?
ETFs and index funds share many similarities; in fact, an index fund can be an ETF. Thus, it’s important to note the technical definitions before comparing the two investments.
An index fund is an investment approach in which investments are chosen based on how closely they track an index (such as the S&P 500). Both ETFs and mutual funds can be set up as index funds.
Since an ETF can be an index fund, we’ll compare and contrast ETFs with index mutual funds. The two investments share similarities in how they’re managed, how their fee structures are set up, and how they offer simple ways to diversify investment portfolios.
Passively managed
The main feature that ETFs and index funds share is passive management. Over the long term, this type of investing typically offers fewer fees and strong returns.
Low cost
Both ETFs and index funds typically have lower costs than actively managed mutual funds. Fewer transactions mean lower fees and lower operating costs.
Diversified investment vehicles
Both ETFs and index funds create investments by grouping together baskets of investments. By investing in an ETF or index fund, you diversify your portfolio.
Simplify investing
Instead of buying individual stocks and bonds, you can buy an ETF or an index fund to own a piece of many different investments. While this may not be your only tactic for diversifying your investment portfolio, it does help simplify it.
What’s the difference between ETFs and index funds?
ETFs and index funds share many similarities, as noted earlier. However, if you’re looking at the difference between ETFs and index mutual funds, there are some clear differences.
| ETFs | Index funds (mutual) | |
|---|---|---|
| Trading frequency and price | Traded throughout the day at market price | Traded once per day on calculated NAV price |
| Transparency | Holdings disclosed daily | Holdings disclosed monthly or quarterly |
| Investment goals | Varied | Replicate returns of a market index |
| Fees | May have fewer fees than an index mutual fund | May have fewer fees than other types of mutual funds, but more than an ETF |
| Taxes | Generally more tax-efficient | Generally less tax efficient |
| Minimum investment | As low as the share price | Minimum set by the mutual fund, often between $250 and $3,000 |
Here is a more detailed look at key differences between EFTs and index funds:
Trading frequency and price
ETFs are traded throughout the day, and their share prices fluctuate accordingly. An index mutual fund, however, can only be bought once at the end of the day, and the price is set.
Transparency
With an ETF, you can see the changes made to the fund by accessing the daily portfolio holding disclosures. If you own index mutual funds, you’ll only know that information monthly or quarterly.
Investment goals
ETFs and index funds will often have different goals. An index fund’s sole purpose is to create investments that mirror those of an index, like the S&P 500. ETFs, on the other hand, can have a variety of purposes or goals. You can choose to invest in ETFs for fixed income, by market cap, by sector, by investment strategy, and more.
Fees
ETFs and mutual funds both charge operating expenses, and the more actively managed a fund is, the more fees you’ll have to pay. ETFs are generally more tax-efficient investments because of their passive nature.
Taxes
You may owe capital gains when you’ve made a profit by selling investments. Actively-managed portfolios may create taxable events where you’ll need to pay the IRS. It’s common for ETFs and index funds to be passively managed, so these taxable events are less common. You might also hold these types of investments in tax-advantaged accounts where they grow tax-free.
Minimum investment
ETF minimums can be as low as the share price, while index mutual funds have a set dollar amount (it could be $250, $3,000, or $100,000, depending on the fund). It’s also possible your brokerage offers fractional share investing for ETFs and index funds, in which case you could invest for as low as $1.
What are the pros and cons of ETFs vs. index funds?
Though they can be quite similar, ETFs and index funds each have advantages and disadvantages.
ETFs
Pros
Low cost: ETFs are passively managed, which results in lower fees.
Diversified: As of the number of investments that are part of the ETF, owning the ETF brings diversification to your portfolio in one investment.
Simple: ETFs are an easy way to gain exposure to a broad slice of the market.
Wide range of investments: Different ETFs can reflect your investing strategy. If you’re looking for an ETF of dividend-paying stocks, you’ll find it.
Cons
Less control: For better or worse, you can’t pick your own stocks when you own an ETF.
Spread: ETFs have a bid and an ask price when traded, which may differ from the net asset value (NAV).
Tracking errors: It’s possible the ETF may not track the index as closely as it’s supposed to, which could cause it to look different from the index or underperform the market.
Index funds
Pros
Low cost: Like ETFs, passively managed funds such as index funds typically have lower costs.
Diverse investment portfolio: Index funds include many types of investments.
Simple: Index funds offer an easy way to gain exposure to a broad slice of the market with a single investment.
Cons
Market risk: With all investments exposed to the stock market, there’s some risk involved with losing money.
Less flexibility: You won’t be able to control the investments in the index (though some might consider that a good thing).
Performance: Since index funds are passively managed and follow an index, they may underperform.
Should I invest in index funds or ETFs?
You can have both ETFs and index funds of any type in your portfolio. You may lean towards one or the other depending on your goals.
Invest in an ETF if you’re looking for:
A fund to outperform the market
Niche investments, markets, or strategies
More tax-efficient investments
Invest in an index fund if you’re looking for:
Passive investments
Low cost
Diversification in investments
Solid returns over time
Bottom line
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Unbiased can connect you to a financial advisor to help you make decisions with the complete picture of your finances in mind.