ETFs vs. index funds: Key similarities and differences
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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. Plus, both investment vehicles can offer built-in diversification; these qualities and more make them ideal for the average investor.
Here we’ll compare these two types of investments to help you decide if either (or both) are right for you.
ETF vs index fund: Here’s how they’re similar
ETFs and index funds are quite similar, and they can serve a lot of the same roles for the investor. Let’s look at what they have in common.
One of the biggest benefits of both index funds and ETFs is how easy they make it to diversify your portfolio. Total stock market funds, for example, track the performance of every publicly traded company in the United States, meaning at the moment, they track nearly 4,000 U.S. companies. Vanguard funds VTSAX and VTI track this same index, but the former is a mutual fund and the latter is an ETF – but they’re both still index funds.
The fees on both index funds and ETFs are low, especially when compared to actively managed funds. Many ETFs track an index, and this investment style keeps fees low. Since the fund changes based only on changes to the index – a passive approach – there are few labor costs associated with index funds.
In 2020, the average expense ratio for index equity mutual funds was 0.06 percent, according to the Investment Company Institute’s latest report. For equity ETFs, it was 0.18 percent. On the other hand, the average fee in 2020 for actively managed mutual funds and ETFs was 0.71 percent and 0.69 percent, respectively.
Index funds and most ETFs simply try to replicate an index of stocks or other assets. They don’t make active trading decisions and try to beat the market. Instead, they try to mimic the index and get its average returns over time.
And investors can use index funds and ETFs as a passive investment strategy. For instance, you may have an employer-sponsored retirement plan that allows you to invest using payroll deductions. If you invest a certain percent of your salary every pay period in index funds, your portfolio will need little to no ongoing maintenance.
The same is true if you invest in ETFs or index funds in a brokerage account. When you buy S&P 500 index funds, for example, most brokers have the option to invest automatically.
Strong long-term performance
Another benefit of both index funds and ETFs is strong long-term performance. An active fund manager or stock picker might make a few winning trades here and there; few, though, can do so for a sustained period and beat the market. Over a five-year period, nearly 80 percent of active fund managers fail to meet or even beat their benchmark.
Meanwhile, index funds and ETFs provide more consistent performance that wins in the long run. The S&P 500, for example, has historically returned about 10 percent per year, on average. This makes index funds and ETFs solid long-term investments.
Key differences between ETFs and index funds
ETFs and index funds present a few differences that investors need to be aware of.
Where to buy
If you invest in a 401(k) or 403(b) through your employer, there is a good chance you will 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 broader range of funds, including a wide variety of mutual funds and ETFs.
Ultimately, online brokers offer you the greatest number of options for buying index funds. The major brokers offer all of the common types of index funds.
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 had a minimum investment of $10,000 in the past. The minimum has since been reduced to $3,000, which is much better, but can still sideline some who don’t readily have that much cash on hand.
When you have an account with an online broker, you can often buy as little as one share of an ETF. Better still, several online brokers now offer trading in fractional shares. 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 fees work differently for mutual funds and ETFs. These days, trading commissions for stocks and ETFs are almost non-existent when you deal with major brokers.
However, index mutual funds can come with hefty trading commissions and may also have load fees, which are a form of sales commission. ETFs have no load fees, either on the front end or the back end.
The lesson here is to see the whole picture in terms of the fees, because even if a mutual fund has a lower expense ratio than an equivalent ETF, that can be offset by trading fees.
If you buy and sell frequently, ETFs are the clear winner when it comes to taxes. When shares of an ETF are sold, only the seller pays capital gains taxes.
That’s different from index mutual funds because you sell these shares to a fund manager. If the fund manager then sells the underlying assets for a gain, those gains are spread among every 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 provides trading throughout the day and rock-bottom fees. If you’re buying an index mutual fund, you’ll likely run into investment minimums of a few thousand dollars, plus you’ll only be able to buy and sell at the end of each trading day.
But it’s important to remember that mutual funds and ETFs aren’t investments in and of themselves, they’re just vehicles for investing in securities like stocks and bonds. If you’re investing in a mutual fund and ETF that both track the same index and therefore hold the same underlying securities, you’re likely to end up with similar performance over longer periods of time as long as the fees for each fund are similar.
Whether you invest in an ETF or an index fund, you are choosing to invest in your future. The differences between the two tend to be small; in fact, index funds are often (but not always) the same thing. Thus, which one you choose is less important than the choice to start investing. In doing so, you take advantage of low fees and diversification, and an investment that will grow over time.