ETF vs. Index Fund: Which is Best for Your Portfolio?

With no shortage of investment vehicles available to investors, it’s imperative to understand the often subtle nuances between them to ensure the investment aligns with investor objectives. Two such investment options that appear similar are an ETF vs. an index fund. 

ETF or exchange traded funds, and index funds offer low-cost and low-maintenance options. However, one of these investment vehicles is likely more suitable than the other based on your investment strategy. Consider the following differences between an ETF vs. an index fund before adding one to your portfolio.

ETF vs. Index Fund

What is an ETF?

An ETF is an investment fund that contains a large pool of investments such as stocks, bonds, commodities, options, and even a combination of them, all in one fund. The ETF owns that pool of underlying securities and divides ownership of them into shares. 

There are several different categories of ETFs available for investors, such as index ETFs, equity ETFs, and sector and industry-specific ETFs, to name a few. For example energy ETFs own energy sector stocks and space ETFs own stocks in the aerospace and space exploration industry.

There are various risks and returns associated with each type of ETF. Some ETFs require minimal oversight, whereas others require active management as shares are traded throughout the day to keep market prices of ETFs in line with their underlying securities. Several criteria must be considered when researching and selecting an ETF.

What is an Index Fund?

An index fund is a type of mutual fund or ETF. The goal of an index fund is to track the performance of a particular index, such as the Standard & Poor’s 500 Index or the Russell 2000 Index. 

An index fund contains shares of all companies that mirror a particular market index. The S&P 500 Index, for example, tracks the performance of the 500 largest companies in the United States. A fund tracking this index would own shares of the same 500 companies and experience the same fluctuations that the S&P 500 would. 

How is ETF vs. Index Fund Similar?

An ETF shares the following similarities with an index fund:

1. Diversification 

An ETF provides the benefit of diversification since the investment fund contains many different stocks. There are riskier ETFs on the market, such as industry or sector-specific funds. However, an ETF with hundreds or thousands of stocks and other instruments or an index ETF that mirrors a benchmark index will not be as volatile due to diversification. 

An index fund can also provide investors with a well-diversified portfolio like an ETF. For example, if a fund is tracking the S&P 500 Index, any risk is dispersed among shares of 500 large U.S. companies. 

2. Long-Term Investment

Index funds are passively managed investments. The strategy for owning an index fund is typically that of ‘buy and hold’ because investors tend to earn strong long-term returns when they ride out some of the poorly performing years. For example, the average annual return for the S&P 500 over the long term is 10%. 

Depending on the type of ETF, they can be passively managed, actively managed, or both. ETFs are generally considered less risky vehicles because of their diversification which can protect investments from volatility. The broad exposure to hundreds of companies’ stocks is why ETFs are an excellent long-term investment. 

3. Low Fees

Because index funds and some ETFs (such as index ETFs) are passively managed, and there isn’t a constant buying and selling of shares, both investment vehicles are relatively low cost.  

Mutual funds and ETFs charge shareholders an expense ratio to pay for operating and managing the funds. Although the expense ratio may be low, there are other fees to look out for, such as load fees for mutual funds and commissions. However, the general trend is that fees are declining, so these passively managed funds with few transactions will also have low fees.  

How is ETF vs. Index Fund Different?

1. Trading

ETFs trade on a stock exchange just like individual stocks. They experience price fluctuations throughout the day, and shares are constantly purchased and sold on the stock market. You can open a brokerage account online and buy shares of an ETF yourself.

Also, since trading constantly occurs throughout the day, estimating the price of an ETF is easier.

For index funds or mutual funds, you buy and sell shares through a fund manager and only at market close after the fund’s net asset value (NAV) is calculated. The fund’s NAV is the total value of its assets less its liabilities, divided by the number of shares outstanding. 

Since the NAV can only be calculated once the market closes, investors won’t know the exact share price they will receive. Investors can buy in fixed dollar amounts and share amounts for index funds to compensate for not knowing the actual share price. For ETFs, investors can only buy or sell on a per-share basis. 

Since index funds are simply mimicking a particular index, no active trading of shares is required. 

2. Minimum Investment 

Index funds generally have higher minimum investment requirements, sometimes in the thousands of dollars. ETFs only require the purchase of one share, plus commissions and fees, if any, at a minimum.

3. Taxes

ETFs are more tax-efficient than index funds. Investors of ETFs don’t have to pay taxes when fund managers are actively trading shares within the fund. 

Conversely, if index fund managers must adjust the portfolio to track the underlying index, they will have to buy and sell the assets, which could trigger a capital gains tax. The capital gains tax from the sale of assets is paid out to every investor who owns shares in the fund in the form of a distribution. However, this wouldn’t happen often as index fund holdings would rarely need to change. 

For ETF and index funds, if an investor sells shares of either investment, they will be subject to any capital gains tax.

The Choice Between an ETF vs. an Index Funds Depends on Investment Objectives

Both ETF and Index Funds provide an investment that has the following benefits:

• Low-cost
• Passively managed
• Diversification
• Better returns over the long-term

If you would like to avoid investment minimums in the thousands of dollars, consider investing in ETFs instead. An index ETF will allow for trading throughout the day and with minimal fees. 

But if you invest in a mutual fund and an ETF that both track the same index, you will likely see similar performance over the same period since they hold the same underlying securities and as long as they have the same fee structure. Both vehicles have benefits that make them worthwhile investments. 

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