Index Fund vs. ETF: What's the Difference?

Index Fund vs. ETF: An Overview

Exchange-traded funds (ETFs) and index funds are similar in many ways but ETFs are considered to be more convenient to enter or exit. They can be traded more easily than index funds and traditional mutual funds, similar to how common stocks are traded on a stock exchange.

Investors can also buy ETFs in smaller sizes and with fewer hurdles than mutual funds. They can avoid the special accounts and documentation required for mutual funds by purchasing ETFs.

Index Mutual Funds

Index funds are funds that represent a theoretical segment of the market. They're designed to act as the performance and make-up of a financial market index. They typically track a specific market index, like the S&P 500. Instead of a fund manager actively picking stocks, the fund mirrors the performance of the index by holding all (or a representative sample) of the stocks or bonds in that index.

You can't invest in an index itself but you can invest in an index fund. You're utilizing a form of passive investing that sets rules by which stocks are included and then tracks the stocks without trying to beat them. Index mutual funds work in a unique way: The index fund holds the same investments as its target index, in the same proportions. As the market fluctuates, the index composition might change. To remain aligned, the fund periodically rebalances its holdings to mirror the updated index proportions. This ensures the fund stays on track with the target benchmark and because they don't require a team of analysts actively researching and managing holdings, they typically come with lower expense ratios.

These types of funds follow a benchmark index like the Nasdaq 100 or S&P 500. Index funds have lower expenses and fees than funds that are actively managed.

Exchange-Traded Funds (ETFs)

Exchange-Traded Funds are a basket of assets that are traded like securities. They're technically investment funds that trade like stocks on a stock exchange. They hold a basket of securities, similar to mutual funds, but offer more flexibility with intraday trading as they can be bought and sold on an open exchange just like regular stocks. Mutual funds are only priced at the end of the day.

Financial experts consider index fund investing to be a rather passive investment strategy compared to value investing.

Value investing often appeals to investors who are persistent and willing to wait for a bargain to come along. Getting stocks at low prices increases the likelihood of earning a profit in the long run. Value investors question a market index and usually avoid popular stocks in hopes of beating the market.

Key Differences

The major difference between index funds and ETFs is their trading mechanism and flexibility. Index funds can only be bought and sold at the end of the trading day, based on the fund's net asset value (NAV). While ETFs trade throughout the day on a stock exchange, just like stocks. Their price fluctuates throughout the day based on supply and demand. What this means is that with index funds, you can buy and sell shares at the end of the day, based on the total value of the fund's holdings at that time, but with ETFs, you have the flexibility to buy and sell shares throughout the trading day at the current market price, which reflects real-time supply and demand.

Other differences between mutual funds and ETFs relate to the costs associated with each. There are typically no shareholder transaction costs for mutual funds. Costs such as taxation and management fees, however, are lower for ETFs. Most passive retail investors choose index mutual funds over ETFs based on cost comparisons between the two. Passive institutional investors tend to prefer ETFs.

When it comes to taxation, ETFs and mutual funds are also different. ETFs are typically more tax-efficient than index funds due to differences in their structure and creation and redemption process. ETFs generally have lower capital gains distributions because of the ability to conduct in-kind creations and redemptions and this helps to minimize taxable events. Additionally, ETFs offer greater tax control for investors through tax-loss harvesting strategies. On the other hand, index funds generate capital gains distributions from buying and selling securities within the fund and this results in higher tax liabilities for investors.

Minimum investment requirements for both funds differ. For index funds, some funds may have minimum investment amounts, although many allow you to start with relatively small sums. Some have minimum investment requirements set by the fund company, which could range from a few hundred to a few thousand dollars. It's quite different for ETFs because ETFs do not usually have minimum investment requirements beyond the price of one share. This means you can typically buy fractional shares of an ETF and this makes them more accessible to investors with limited capital.

Liquidity also distinguishes index funds from ETFs. Since index funds are bought and sold at the end of the trading day, liquidity is not as readily available compared to ETFs. ETFs trade on stock exchanges, this being the case, liquidity is provided throughout the trading day. Investors who need to enter or exit positions quickly will find this very advantageous and this makes index funds different from ETFs.

The Bottom Line

Both index mutual funds and ETFs can provide investors with broad, diversified exposure to the stock market, making them good long-term investments suitable for most investors. ETFs may be more accessible and easier to trade for retail investors because they trade like shares of stock on exchanges. They also tend to have lower fees and are more tax-efficient.

Correction—Sept. 10, 2024: This article has been corrected to state that ETFs tend to be more tax-efficient, while index funds may incur a capital gains tax.