ETF vs. Index Fund: Which Is the Best Option for You?

Exchange-traded funds are an increasingly popular investment option because of their low costs, flexibility and tax advantages. They also give you exposure to the stock market without having to pick the stocks yourself, making them similar to index funds. But there are also important differences.

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Read on to learn about the similarities and differences between an ETF and an index fund.

Key Takeaways

• An index mutual fund is a type of mutual fund that aims to replicate the performance of a financial index, such as the S&P 500.

• Most ETFs are index funds.

• While ETFs and index mutual funds both track a particular index, their different structures affect how you trade them and how you’re taxed on gains.

What Is an Index Fund?

Because an index fund is a type of mutual fund, it helps to understand what a mutual fund is. A mutual fund is essentially a pool of money collected from different investors and overseen by a professional fund manager who puts the money into different investments. Investors don’t directly own individual stocks in the fund, though they do share in any of its profits or losses.

What separates an index fund from the more common traditional mutual fund is that it’s not actively managed by a financial manager. Instead, it is set up to automatically replicate the performance of a specific market index. For example, the Vanguard 500 Index Fund attempts to replicate the S&P 500.

When you invest in an index fund, you invest in all of the investments in an index, which helps diversify your portfolio. Because index fund managers buy and hold rather than trade frequently, the funds are cheaper to manage.

What Is an ETF?

An exchange-traded fund is a hybrid of sorts that combines features of both individual stocks and mutual funds. It’s similar to a mutual fund in that it invests in a basket of stocks. But it trades on stock exchanges whenever the markets are open, just like stocks.

Most ETFs are passively managed and track a particular index, so they are, in fact, index funds.

ETF vs. Index Fund: Key Differences

Although index mutual funds and most ETFs are both index funds, their differences could make one a better fit for you.

How They’re Traded

One of the biggest differences between index funds and ETFs is the frequency with which you can trade them.

Index funds, like all mutual funds, trade just once a day, after the markets close. The prices are based on the net asset value of the underlying securities after trading ends for the day.

Because ETFs trade like stocks, the price depends on supply and demand for the security. Buyers can take advantage of pricing dips during the day to buy at more favorable prices. Similarly, if an investor thinks an ETF will gain in value, they can buy early to take advantage.

However, ETF trades are subject to spreads and premiums or discounts. A spread is the difference between the highest price a buyer will pay for a share and the lowest price a seller will accept. A premium or discount is the difference between the market price of a share and the underlying value of its assets.

Minimum Investment

The minimum investment needed for an ETF is the price of a single share. Some brokers, like Betterment and Fidelity, even let you invest in fractional shares of an ETF. Index funds, on the other hand, might require a minimum investment of several thousand dollars.

This minimum differs from broker to broker, and not all brokers impose them on every fund. But it’s not uncommon to see minimum investments of $1,000 and higher. For example, the Vanguard 500 Index Fund Admiral Shares requires a minimum investment of $3,000.

If you’re looking to invest in an index fund but don’t have much money, a number of funds that require a low (or no) minimum are available, such as the Fidelity Zero Large Cap Index Fund and the Schwab S&P 500 Index Fund.

Tax Efficiency

ETFs and index funds are subject to capital gains tax, but the events that trigger the tax differ. As a result, ETFs are more tax-efficient.

When you sell an ETF share, the share is transferred to another owner, as TurboTax explains on its website. The transaction takes place between you and the buyer on the open market, so the shares are transferred rather than redeemed.

Not so with an index fund. When you “sell” a share in a mutual fund, you actually redeem it — you give it back to the fund in exchange for cash. Because all shareholders own a piece of the fund, that redemption can trigger a tax liability.

Also, mutual funds need to be rebalanced more frequently — fund managers buy and sell assets to keep the portfolio balanced as intended. Each trade they make to rebalance can also trigger a tax liability for shareholders.

ETFs can lessen the tax impact in a portfolio through a process called in-kind redemptions. When redemptions occur from an ETF portfolio, they tend to be done in securities rather than cash, which provides certain tax advantages to investors.

Dividends

Dividends can be an important component of any investment. You can earn them with either an ETF or an index fund, but they’re handled differently.

Because ETFs are traded like stocks, dividends and interest earnings from the underlying securities are distributed to shareholders at the end of each quarter — assuming the holdings in the portfolio pay dividends and the fund earns interest. Most ETF investors receive these dividends.

However, not all index funds pay dividends. The ones that do might only distribute them once a year. What’s more, the size of the distribution is not necessarily proportionate to the number of shares an investor holds. With ETFs, owning more shares usually earns you larger distributions.

Key Similarities Between Index Funds and ETFs

Index funds and ETFs have many features in common.

Passively Managed

The main thing that index funds and typical ETFs have in common is that they’re both passively managed investment vehicles that involve tracking a market index and pooling investors’ money into a basket of securities. Unlike actively managed mutual funds, which are designed to outperform a certain benchmark index, index mutual funds and most ETFs aim to track and match the performances of certain market indexes, regardless of whether the index is falling or on the rise.

Diversify Your Portfolio

Index funds and ETFs both offer exposure to a range of stocks, bonds and other investments within a single investment. This adds a measure of safety to your portfolio compared to investing in individual stocks or other assets because it spreads the risk across many different securities.

Affordable Ways To Invest

ETFs and index funds are both affordable ways to invest. ETFs are available at all price levels, beginning at under $25 as of May 7. When it comes to index funds, you can invest a flat dollar amount if you’d rather not purchase a whole share.

Both Have Fees

While many brokers offer commission-free trading, you’ll likely have other fees to pay.

ETF fees are expressed as an operating expense ratio consisting of an annual percentage of your investment value. The fund uses money from this fee to cover its expenses.

Mutual funds, including index funds, impose fees that are expressed as an expense ratio.

ETF ratios tend to be lower. According to a report from Fidelity, Morningstar calculated the average index ETF expense ratio to be 0.48% in 2023, while the average index mutual fund ratio was 0.81%.

Some mutual funds also have sales loads, which are fees the mutual funds pay brokers but recoup from investors. You might also pay a fee for purchasing shares, redeeming shares or exchanging them for shares in another fund.

How To Invest In ETFs

To start investing in ETFs, you’ll need a brokerage account. Look for one that offers commission-free trades via an easy-to-use mobile or desktop platform.

Once you’re all set up, go to your broker’s search or screening tool to select your ETFs. That looks different for each brokerage, but you’ll look at the same fund features regardless:

• Index or benchmark: The ETF’s holdings depend on the index it tracks or, less commonly, the benchmark it aims to outperform. If you want a broad ETF that represents the whole, or almost whole, market — which is what experts usually recommend for new investors — look for a core index fund that has the words “total market” or “S&P 500” in its name.

• Fees: Compare fees for each ETF you’re considering, but be sure to compare index fund to index fund and/or actively managed fund to actively managed fund for the most accurate comparison.

• Dividend yield: This is the percentage of each share’s value returned to you as a dividend.

• Performance: Compare the ETFs’ recent performance and their performance over time. Also look at the ETFs’ performance in the context of the funds’ objectives, which you’ll see in the overview provided in the ETF information on the brokerage’s website.

How To Invest In Index Funds

Investing in index funds is very similar to investing in ETFs. You’ll start by opening an account with your choice of brokerage. Then begin your search for the right fund by using the brokerage research and screening tools. Here’s what to look for:

• Index: The index determines what you’re investing in, and it can range from a very broad index like the S&P 500 to a narrow one for a certain sector or investing style, such as energy or value funds.

• Fees: Compare expense ratios and also check to see if the fund charges sales loads or other fees not included in the expense ratio.

• Dividend yield: This is the amount of each share’s value you receive as a dividend. When looking at fund information, you’ll typically see a 30-day SEC yield as well as a trailing yield.

• Performance: You can check recent performance as well as long-term performance, to see gains and losses over time. Also check to see how the fund performs against its index — it should match the index.

• Minimum investment: A high minimum could be a deal breaker if you have limited funds to invest, or you want to spread your money among several index funds.

ETF vs. Index Fund: Which Is Better?

Deciding whether an index fund or ETF is the better choice depends on your individual financial goals. Here are some questions to ask yourself before making a decision.

What Does the Index Track and How Long Has It Been Around?

Index funds and ETFs that track long-standing indexes such as the S&P 500 and Russell 3000 have stood the test of time, producing consistently strong returns over the years. However, many index funds and ETFs now track much more arcane segments of the market that pose a higher risk. If you are a moderate to conservative investor, your best option is to buy a fund or ETF with a proven track record.

How Much Will It Cost To Invest?

If you want to keep costs low, use an online brokerage that doesn’t charge a commission. Leading names include Vanguard, Fidelity, E-Trade and Charles Schwab.

Kyle O’Dell and Vance Cariaga contributed to the reporting for this article.

This article has been updated with additional reporting since its original publication.

This article originally appeared on GOBankingRates.com: ETF vs. Index Fund: Which Is the Best Option for You?