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When it comes to investing, there’s no shortage of asset classes. From stocks to bonds and mutual funds to fixed income, it’s important to understand the ins and outs of different types of investments before you make them so you can find the best choice for you as an investor.
If you find yourself asking questions like are exchange-traded funds (ETFs) the same as mutual funds, or are index funds bad for investors, read on to learn the similarities and differences between ETFs and index funds, and how each type of fund works.
What is an ETF (exchange-traded fund)?
So, what is an ETF? It's an investment fund that can combine stocks, bonds, commodities and other investment assets. Like mutual funds, ETFs enable investors to pool their money and invest in multiple securities at once. However, unlike mutual funds, they trade on stock exchanges, meaning their market prices fluctuate throughout the day, whereas mutual fund prices are set at the end of each trading day.
Each ETF is an investment company registered with the Securities and Exchange Commission (SEC) that an investment advisor can either actively or passively manage. Hence, there are two main types of ETFs:
- Index-based ETFs are passively managed funds that track indexes like the broad S&P 500 or the small-cap Russell 2000 Index. Advisors construct these funds to closely mirror the underlying benchmark index with minor differences.
- Actively managed ETFs don’t track an index. Instead, these funds have investment goals that aim to outperform a benchmark index or a sector of an index. Advisors work to achieve this by buying and selling assets to constantly reshape the portfolio and its holdings for optimal performance.
How do ETFs work?
ETFs act similarly to mutual funds, with multiple investors pooling funds in order to purchase large amounts of assets in which they share profits or losses. In return, long-term investors hope to see their shares appreciate similarly to a stock, and in some instances, receive dividend payments. Unlike mutual funds, ETFs are traded on stock exchanges, so you can buy and sell them on the best online stock trading platforms. ETFs may even include mutual funds among their holdings.
Depending on the goals of an ETF, investment advisors can design them to track investment strategies, sectors, commodities or other assets. For example, the Energy Select Sector SPDR Fund aims to outperform the S&P 500’s energy sector by investing in a basket of stocks in the energy industry. Among the ETF’s holdings are oil majors like Exxon Mobil, Chevron and ConocoPhillips. Another example would be gold ETFs, which are leveraged toward the precious metal and can include investments in physical gold itself or companies that mine it.
What is an index fund?
Index funds are funds created to mirror the returns of the benchmark index by providing a specific mix of assets that represent the index. Index funds meet their investment goals by using stocks, bonds and derivatives like futures and options to track these indexes.
Some of the well-known indexes that index funds track are the aforementioned S&P 500 and the Russell 2000 Index, as well as the Nasdaq, the Dow Jones Industrial Average and the Wilshire 5000 Total Market Index.
How do index funds work?
Whereas an index measures the performance of a market or submarket, an index fund aims to mirror the performance of an index. They’re often passively managed, meaning a fund’s manager doesn't need to make many adjustments to the securities as the goal is typically long-term growth mirroring the underlying benchmark index. In most cases, the benchmark index the fund is tracking doesn’t change much over time, and in turn, neither does the index fund itself.
Because there isn’t a lot of trading, index funds have less capital gains tax and lower expense ratios compared to ETFs or other funds. The success of an index fund depends on the market index it tracks.
ETF vs. index fund: What is the difference between an ETF and an index fund?
While ETFs and index funds have a lot in common, there are some differences you should know before deciding which investment is right for you. The main differences between the two include trading fees and trading times, availability of fractional shares, minimum investment requirements and tax efficiencies.
Trading fees and time
You can buy and sell ETFs like stocks through brokerage platforms, and now very few brokerages charge trading fees. Through most online brokerages, there’s no commission for ETFs, which makes them attractive investments for all investors. Some index funds have a sales charge that you pay upfront when you purchase them. The sale charges are commissions that go to the fund manager.
One limitation for index funds is that they can only be traded once a day after the market closes. Buying, selling or trading shares always occurs after the next market close. Contrarily, ETFs — similarly to stocks — can be traded at any time during market hours.
Availability of fractional shares
When purchasing an index fund, you don’t have to pay a set amount to buy an even number of shares. Once you’ve invested more than the minimum investment requirement, your purchase can be broken down into fractional shares. A fractional share is owning a portion of a full share of an investment. For example, if one share costs $500 and you invest $250, you will own 0.5 shares.
While index funds have historically been available in fractional shares, that's not always the case with ETFs. Although some brokerages allow you to buy ETFs as fractional shares, that isn't universal. Additionally, some brokerages that offer dividend reinvestment plans allow for fractional share ownership, but don’t allow you to purchase fractional shares directly.
Minimum investment requirement
ETFs don’t have any minimum investment requirements beyond the price of a single share (or a fractional share if they’re offered). By contrast, there are typically minimum initial investment requirements for index funds, which vary by index fund and brokerage. Vanguard, for example, has a minimum investment requirement of $3,000 to buy into one of its index funds.
In most cases, if you’ve held an ETF for over a year, you need to pay long-term capital gains tax when you sell it. The capital gains tax rate depends on your taxable income and is either 0%, 15% or 20%. If you own an ETF for under a year, it’s taxed as ordinary income.
If an ETF pays dividends, those are taxed differently. If you’ve owned the ETF fewer than 60 days, dividend payments will be taxed at your normal income tax rate. However, if you’ve owned the ETF for more than 60 days, dividends are considered "qualified," and qualified dividends are generally not taxed above 20%.
Comparatively, investing in an index fund can create some negative tax situations. The entire index fund gets taxed yearly, which means you may need to pay capital gains taxes regardless of whether or not you sell your share of the fund. Also, if other fund members sell their shares, the fund manager may need to sell some of the fund to meet the demands of monetary requests. If these sales lead to a profit, you must pay taxes on those gains even if the overall fund is at a loss.
What do index funds and ETFs have in common?
Index funds and ETFs share many similarities. Both investment vehicles aim to replicate aspects of the stock market in order to track or outperform its growth. Some of the common features between the two types of equities are their low expense ratios, the portfolio diversification they offer and the long-term investing benefits they can produce.
Low expense ratios
Expense ratios are fees charged to investors for management, administration, marketing and other costs associated with a managed fund. They take the form of a percentage of your investment. Actively managed funds typically have higher expense ratios, as fund managers employ different strategies to turn a profit and therefore put more time into them. However, even for actively managed ETFs, fees are generally lower than the average expense ratio for mutual funds.
On the whole, both ETFs and index funds typically offer lower expense ratios compared to mutual funds. In many instances, this is because these funds can mirror a market index or sector, in which case little oversight is needed and fees are therefore reduced.
Diversification is the act of allocating funds to a variety of assets and equities to balance your portfolio and offset losses. It’s the central principle behind numerous investment strategies, and it’s something offered by both index funds and ETFs.
Keeping your portfolio spread out across different markets and assets is essential in minimizing risk for your overall investments. It’s why the old adage, “Don’t put all your eggs in one basket,” still applies to investing. With a properly diversified portfolio, a variety of investments can mitigate overall losses during economic downturns or recessions.
Long-term investing benefits
By investing in ETFs and index funds over the long term, investors can potentially profit without putting forth much effort. That’s largely because the investment vehicles, which often track large indexes like the S&P 500, follow the general trajectory of the stock market, which tends to go up over time.
While there is no guarantee that the major indexes will rise, historically, they have steadily climbed over time. That’s often demonstrated by applying the compound annual growth rate (CAGR) to an index like the S&P 500, which over the past 30 years has produced a CAGR of 10.7% per year. That means if in 1993 you invested $1,000 in an ETF or index fund that mirrors the S&P 500, in 2023 that initial investment would be worth $21,107.10 (before accounting for dividends, expense ratios and taxes).
Mutual fund vs. ETF vs. index fund
Mutual funds, index funds and ETFs are similar because they offer baskets of stocks, bonds and other financial assets in which a large number of investors can pool their money. While most index funds and many ETFs are passively managed, mutual funds are often actively managed by a fund manager who buys and sells financial securities to make a profit for investors. This buying and selling can often accumulate more capital gains taxes than index funds and ETFs do, meaning with mutual funds, the tax liability is often higher. Furthermore, like index funds, you can only buy and sell mutual funds at the end of the trading day after market close.
How to invest in index funds
If you decide to invest in an index fund, you can do so by either setting up a brokerage account or purchasing it from a mutual fund company directly. Online brokerages and trading apps are now the most popular option, but if you prefer, you can visit a brick-and-mortar location and apply in person.
Note: Some popular brokerages, like Robinhood and Webull, don’t have physical locations.
Some of the most popular brokerages include:
When you’ve settled on the brokerage, you can begin researching different index funds. Consider their costs (i.e., expense ratios) and historical performances before purchasing the index fund.
How to invest in ETFs
Like buying an index fund, investing in ETFs is a straightforward process. You’ll need a brokerage account in order to invest. Next, determine the ETFs you think will yield the best results over time. You should list the ETFs that you’re considering; scrutinize their expense ratios and the indexes, sectors, commodities or themes they track; and then determine which investment is right for you. Remember to also consider whether or not the ETFs are actively or passively managed.
Which is better, an index fund or ETF?
ETFs and index funds are both excellent options for long-term investors. Because they’re often passively managed, they don’t accumulate a lot of capital gains taxes. Generally, they both track a sector, index or the entire stock market, which can help you diversify your portfolio. Both of these investment vehicles have relatively low expense ratios, which can save you money in the long run.
Choosing which option is best for you will depend on your personal financial situation and investment goals. Because index funds usually require a minimum initial investment, beginning with an ETF may be the best choice if you’re new to investing or have minimal funds to invest, since ETFs typically don’t have minimum investment requirements.
Summary of Money’s ETF vs. Index Fund
Index funds and ETFs are investment options that you should be familiar with when building your portfolio. In some aspects, ETFs and index funds are similar. Both have low expense ratios, can help diversify your portfolio and have long-term investing benefits. But there are some differences. Index funds and ETFs differ in trading fees and trading times, availability of fractional shares, minimum investment requirements and tax efficiencies. No matter which you choose, both can offer investors stable, long-term growth.