Paid non-client promotion: Affiliate links for the products on this page are from partners that compensate us (see our advertiser disclosure with our list of partners for more details). However, our opinions are our own. See how we rate investing products to write unbiased product reviews.
- ETF and index funds are baskets of securities providing long-term returns and diversification.
- ETFs are better suited for low-cost investors seeking easy exposure to a specific part of the market.
- Index funds are better suited for those wanting broader market exposure.
Index funds and ETFs are two of the easiest strategies for portfolio diversification — basically, owning a mix of investments within and across asset classes.
These funds bundle several securities into one investment, giving you broader exposure to different companies and market sectors. Many of the best online brokerages offer both index funds and ETFs.
"Stock market indexes — like the S&P 500, Nasdaq, and Dow Jones Industrial Average — are not directly investable," says Chris Berkel, an investment advisor and founder of AXIS Financial. "There is no way to buy the S&P 500 index (for example). However, you can invest in a fund that tracks it."
Let's unpack the differences and similarities of ETFs and index funds so you can find the best basket of securities for your portfolio.
Understanding ETFs and index funds
ETFs and index funds both use a passive investment approach and grant investors quick access to diversification.
What are ETFs?
Exchange-traded funds (ETFs) are investment vehicles, like stocks, that can be bought and sold on an exchange.
But instead of representing a share within one company, "an ETF is typically a basket of securities like stocks, bonds, commodities, options, or a combination," Berkel says. "ETF issuers can choose to track an index or do something more custom to tackle a specific market anomaly."
ETFs aim to follow the market, whereas other investments, like mutual funds, aim to beat it. When you buy a share in an ETF, you own a portion of the fund but not the underlying assets.
What are index funds?
An index fund is a type of mutual fund or ETF that tracks a particular market index. "They do this by replicating the underlying constituents in the index," Berkel says.
An index fund manager pools money from many investors and builds a portfolio that mimics the composition of a target index so the fund's value will mirror the gains and losses of the index being tracked.
The fund manager then sells shares of the index fund to investors, regularly adjusting the portfolio's assets and shares and rewarding the fund's investors with dividends, interest, and capital gains.
Key similarities between ETFs and index funds
Index funds and ETFs have key similarities such as:
- Instant diversification
- Passive management style
- Lower fees compared to actively managed funds
- Strong long-term returns
Key differences: ETFs vs index funds
The key differences between ETFs and indexes are as follows.
Trading
One major difference between ETFs and index funds is the way they trade. ETFs trade on exchanges, meaning investors can buy and sell them like stocks during normal trading hours.
Index funds, however, must be purchased and traded at the end of the trading day.
Pricing
An ETF's price can fluctuate throughout the day as it trades like a stock. Investors can also buy shares of ETFs long or sell them short, which can impact the value of these equities.
Index mutual funds are priced once a day after the market closes, when their net asset value, calculated by taking a fund's assets and then subtracting its liabilities, is calculated. Using this approach, a mutual fund's assets are determined by adding the value of the different securities in its portfolio.
Tax efficiency
Investing in ETFs instead of index mutual funds can generate greater tax efficiency. Investors who hold these funds only pay taxes when they sell these securities.
Investors who own mutual fund shares are liable for paying some capital gains taxes when these funds sell assets and realize a gain in the process.
Accessibility
ETFs and mutual funds can offer differing levels of accessibility. More specifically, gaining exposure to an ETF requires purchasing only one share, while buying most mutual funds involves an investment of at least $500.
In other words, investors can potentially gain exposure to an ETF with a smaller initial capital outlay than a mutual fund.
Choosing between ETFs and index funds
Depending on your goals and investment priorities, an ETF or index fund may be better suited for your needs.
ETFs might be better if…
ETFs might be better if you're looking for an easy way to trade shares like stocks. ETFs are generally more accessible for retail investors seeking instant diversification in one or multiple market sectors without excessive fees.
"ETFs make more sense for investors trying to get exposure to a specific part of the market or who are trying to integrate risk management techniques into the portfolio," Berkel says. "Examples of this might be accessing the highest quality stocks from undervalued countries around the world or managers using options to mitigate downside portfolio risk."
Index funds might be better if…
Index funds might be better if you're an investor seeking broad exposure to a specific market segment without paying significant spread fees.
Further, some index funds have no sales load as the commission is paid when purchasing. Past that, some index mutual funds have total expenses below that of a comparable ETF.
An index fund could be a good way to minimize risk because the price of individual stocks may rise and fall, but indexes tend to increase over time.
ETF vs. index fund FAQs
ETFs tend to have lower overall fees compared to index funds. However, index funds don't trade like stocks, making them a better option for lower spread fees. Be sure to evaluate the expenses associated with individual funds when considering them.
When comparing ETFs vs index funds, ETFs are better for retail investors seeking low-cost and easy diversification. Index funds are better for broader market exposure and lower spread fees.
You do need a broker to purchase ETFs. However, you do not necessarily need one to buy an index fund, as financial institutions offering index funds offer them directly.
Both ETFs and index funds have their unique costs and benefits. Those planning for retirement can benefit from evaluating both.
