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Index funds and exchange-traded funds (ETFs) are both great wealth-building tools that work well in many different investment scenarios. But it’s important to note that index funds are often ETFs, and ETFs are almost always index funds.
Both index funds and ETFs are often low-cost and passively managed, meaning they can be a ‘set it and forget it’ solution. Additionally, both investment vehicles can offer built-in diversification; these qualities and more make them ideal for the average investor.
Here we compare these two types of investments to help you decide whether one (or both) is right for you.
ETF versus index fund: they are so similar
ETFs and index funds are quite similar and can serve much of the same role for the investor. Let’s take a look at what they have in common.
Diversification
One of the biggest advantages of both index funds and ETFs is how easy they make it to diversify your portfolio. For example, total stock market funds track the performance of every publicly traded company in the United States, meaning they currently track nearly 4,000 U.S. companies. Vanguard funds VTSAX and VTI track the same index, but the former is a mutual fund and the latter an ETF – but they are both still index funds.
Low costs
Expenses for both index funds and ETFs are low, especially compared to actively managed funds. Many ETFs track an index, and this investment style keeps costs low. Because the fund only changes based on changes in the index – a passive approach – there are few labor costs associated with index funds.
According to the latest report from the Investment Company Institute, the average expense ratio for index stock funds in 2023 was 0.05 percent. For equity ETFs this was 0.16 percent. On the other hand, the average fee in 2023 for actively managed mutual funds and ETFs was 0.66 percent and 0.68 percent, respectively.
Passive investments
Index funds and most ETFs simply attempt to replicate an index of stocks or other assets. They do not make active trading decisions and try to beat the market. Instead, they try to mimic the index and match its returns over time.
And investors can use index funds and ETFs as a passive investment strategy. For example, you may have an employer-sponsored retirement plan that allows you to invest using payroll deductions. If you invest a certain percentage of your paycheck in index funds each pay period, your portfolio will require little to no ongoing maintenance.
The same applies if you invest in ETFs or index funds in an investment account. For example, when you buy S&P 500 index funds, most brokers offer the option to invest automatically.
Strong long-term performance
Another advantage of both index funds and ETFs is their strong long-term performance. An active fund manager or stock picker may make a few winning trades here and there; However, few can do this for long periods of time and beat the market. Over the long term, most active fund managers fail to beat or even meet their benchmark.
Meanwhile, index funds and ETFs offer more consistent performance that delivers profits over the long term. For example, the S&P 500 has historically returned an average of about 10 percent per year. This makes broadly diversified index funds and ETFs solid long-term investments.
ETFs vs. Index Funds: How They Differ
ETFs and index funds have some differences that investors should be aware of.
Where to buy
If you invest in a 401(k) or 403(b) through your employer, chances are you have index mutual funds as an investment option, but not ETFs.
If you want to buy ETFs, your best bet is usually to open an IRA, Roth IRA, or a taxable brokerage account. Depending on where you open these accounts, you will likely have access to a much wider range of funds, including a wide variety of mutual funds and ETFs.
Ultimately, online brokers give you the greatest number of options for buying index funds. The major brokers offer all common types of index funds.
Minimal investments
Investment minimums vary depending on the type of index fund. For example, mutual funds have investment minimums that can be a barrier for some investors. Vanguard’s VTSAX historically had a minimum investment of $10,000. The minimum has since been lowered to $3,000, which is much better, but it can still sideline some who don’t have that much cash on hand.
When you have an account with an online broker, you can often buy only one share of an ETF. In fact, several online brokers now offer fractional share trading. These fractional shares allow you to buy as little as 1/100,000th of one share in some cases, meaning you can invest exactly as much as you want.
Trading costs
Trading fees work differently for mutual funds and ETFs. Today, trading commissions for stocks and ETFs are almost non-existent when dealing with major brokers.
However, index mutual funds can incur high trading commissions and may also charge loading fees, which are a form of sales commission. ETFs have no loading fees, either on the front or back end.
The lesson here is to see the whole picture in terms of costs, because even if a mutual fund has a lower expense ratio than an equivalent ETF, this can be offset by trading costs.
Tax strategy
If you buy and sell regularly, ETFs are the clear winner when it comes to taxes. When shares of an ETF are sold, only the seller pays capital gains taxes.
This is different from index investment funds, because you sell these shares to a fund manager. If the fund manager then sells the underlying assets at a profit, these profits are distributed to each investor who owns shares in the fund.
Index Funds or ETFs: Which Are Better?
Determining whether an index fund or ETF is better is difficult because the answer depends on the specific funds being discussed and your goals as an investor. Many index funds are available in ETF form, which allows all-day trading and has very low costs. If you buy an index mutual fund, you’ll likely encounter investment minimums of a few thousand dollars, plus you can’t buy and sell until the end of each trading day.
But it’s important to remember that mutual funds and ETFs are not investments in themselves, but merely vehicles for investing in securities such as stocks and bonds. If you invest in a mutual fund and an ETF that both track the same index and therefore hold the same underlying securities, you are likely to achieve similar performance over longer periods of time, as long as the costs for each fund are comparable. .
In short
Whether you invest in an ETF or an index fund, you choose to invest in your future. The differences between the two are usually small; in fact, index funds and ETFs are often (but not always) the same. Which one you choose is therefore less important than the choice of whether to invest. You benefit from low costs and diversification, and from an investment that will grow over time.
