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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.
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Index fund vs. ETF
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 may better suit your needs. They can be traded like stocks, yet investors can still reap the benefits of diversification.
ETFs may also have lower minimum investments and be more tax-efficient than most index funds.
Despite their differences, index funds and ETFs do have a lot in common including diversification, low costs to invest and strong long-term returns.
More differences between ETFs and index funds
In addition to how they're traded, there are a few other differences between index funds and ETFs.
1. 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 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. If you have only a small amount to invest, consider an ETF with a share price you can afford or an index fund that has no minimum investment amount.
2. 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.
» Ready to invest? See our picks for the best brokers for fund investing.
3. The cost of owning them
Both ETFs and index funds can be very cheap to own from an expense ratio perspective — you can easily find funds that cost less than 0.05% of your investment per year.
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
What index funds and ETFs have in common
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.
Both index funds and ETFs can help you create a well-diversified portfolio. For example, an ETF based on the S&P 500 will give you exposure to hundreds of the country’s largest companies. See a few S&P 500 ETFs here.
2. Low cost
Index funds and ETFs are passively managed, meaning the investments within the fund are based on an index, such as the S&P 500. 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. A few actively managed ETFs do exist but for this comparison, we'll be focused on the more common passively managed variety.
3. 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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