Wondering whether exchange-traded funds, also known as ETFs, or index funds are a better investment for you? The truth is, they share more similarities than differences, but there are a few considerations that could help you decide.
What ETFs and index funds have in common
First, the similarities. ETFs and index funds both bundle together many individual investments — such as stocks or bonds — into a single investment, and they've become a popular choice for investors for a few shared reasons:
Low cost. Index funds and ETFs are passively managed, meaning the investments within the fund are based on an index, which is a subset of the broader investing market. This is compared with an actively managed fund (like many mutual funds), in which a human broker is actively choosing what to invest in, resulting in higher costs for the investor in the form of expense ratios. A few actively managed ETFs do exist but for this comparison, we'll be focused on the more-common passively managed variety. In 2018, the average annual expense ratio for passively managed funds was 0.15%, compared with actively managed funds’ average expense ratio of 0.67%.
Strong long-term returns. For long-term investors, passively managed index funds tend to outperform actively managed mutual funds. Passively managed investments follow the ups and downs of the index they’re tracking, and these indexes have historically shown positive returns. The annual total return of the S&P 500, for example, has averaged around 10% over the last 90 years.
Actively managed mutual funds may perform better in the short term because fund managers are making investment decisions based on current market conditions and their own expertise. But the improbability that fund managers will make consistent, market-beating decisions over a long period — not to mention the higher expense ratios — can lead to lower returns over time versus passively managed funds.
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The differences between index funds and ETFs
While ETFs and index funds have many of the same benefits, there are a few distinctions to note between the two.
1. The way they’re bought and sold
The biggest difference between ETFs and index funds is that ETFs can be traded throughout the day like stocks, whereas index funds can be bought and sold only for the price set at the end of the trading day.
For long-term investors, this issue isn’t of much concern. Buying or selling at noon or 4 p.m. will likely have little impact on the value of the investment in 20 years. However, if you’re interested in intraday trading, ETFs are a better way to go. They can be traded like stocks, yet investors can still reap the benefits of diversification.
The biggest takeaway is that both ETFs and index funds are great for long-term investing, but with ETFs, investors have the option to buy and sell throughout the day. And although they trade like stocks, ETFs are usually a less risky option in the long term than buying and selling stocks of individual companies.
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2. The minimum investment required
In many cases, ETFs will have a lower minimum investment than index funds. Most of the time, all it takes to invest in an ETF is the amount needed to buy a single share, and some brokers, such as Robinhood, even offer fractional shares.
But for index funds, brokers often put minimums in place that might be quite a bit higher than a typical share price. Vanguard, for example, has a minimum investment of $3,000 for most of its index funds, while T. Rowe Price has a minimum initial investment of $2,500.
However, online brokers that don’t have minimum initial investments do exist. If you have only a small amount to invest, consider two options: an ETF with a share price you can afford or an index fund that has no minimum investment amount. Also be sure that your brokerage doesn't impose an account minimum you can't meet, though many brokers today have lowered their minimums to zero.
3. The capital gains taxes you’ll pay
ETFs are more tax efficient than index funds by nature, thanks to the way they’re structured. When you sell an ETF, you’re typically selling it to another investor who’s buying it, and the cash is coming directly from them. Capital gains taxes on that sale are yours and yours alone to pay.
To get cash out of an index fund, you technically must redeem it from the fund manager, who will then have to sell securities to generate the cash to pay to you. When this sale is for a gain, the net gains are passed on to every investor with shares in the fund, meaning you could owe capital gains taxes without ever selling a single share.
This happens less frequently with index funds than with actively managed mutual funds (where buying and selling occur more regularly), but from a tax perspective, ETFs generally have the upper hand over index funds.
4. The cost of owning them
Both ETFs and index funds can be very cheap to own from an expense ratio perspective.
For example, Schwab’s Broad Market ETF and Vanguard’s S&P 500 ETF both have expense ratios of 0.03% as of this writing, meaning you’ll pay just 30 cents per year for every $1,000 invested. Schwab’s S&P 500 index fund also has an extremely low expense ratio of 0.02%, while Vanguard’s Total Stock Market Index Fund Admiral Shares has an expense ratio of 0.04%.
Another cost to look for is trading commissions. If the broker does charge a commission for trades, you’ll pay a flat fee every time you buy or sell an ETF, which could eat into returns if you’re trading regularly. But some index funds also come with transaction fees when you buy or sell, so compare costs before you choose either.
When buying ETFs, you’ll also incur a cost called the bid-ask spread, which you won’t see when purchasing index funds. However, this expense is usually very small if you’re buying high-volume, broad market ETFs.
In the end, index funds and ETFs are both low-cost options compared with most actively managed mutual funds. To decide between ETFs and index funds specifically, compare each fund’s expense ratio, first and foremost, since that’s an ongoing cost you’ll pay the entire time you hold the investment. It’s also wise to check out the commissions you’ll pay to buy or sell the investment, though those fees are usually less important unless you’re buying and selling often.
» Related: 25 best performing high-dividend ETFs
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