On first glance, there doesn’t seem to be any huge difference between ETFs and index funds. After all, they’re both bundles of securities that track the performance of those assets on a listed market, right? Well, sort of.
What are index funds and ETFs
Before we can dive deeper into the specifics of how an ETF differs from index funds in general, let’s take a step back and do a quick refresher course on what these terms actually mean. An ETF stands for exchange traded fund and refers to an investment fund that lets you buy a large basket of individual stocks or bonds in one purchase. A good way to think of an ETF is to imagine a basket filled with stocks, bonds, and a wide variety of other assets you might want to invest in. ETFs are often considered to be a budget-friendly investing tool because they tend to be much cheaper than their more pricey cousins, the mutual fund.
Instead of being managed by a human fund manager who often requires things like a salary and commissions for trades, ETFs tend to be programmed with an algorithm that simply tracks an entire economic sector or index, like the S&P 500 or the US bond market (hence them functioning as a type of index fund).
Index funds, as the name suggests, are any funds that function as a miniature copy of an established market index, such as the S&P 500 or the Dow Jones Industrial Average. For example, if an index fund tracks the S&P 500, then that fund will contain fractional shares of every company listed on that market, and will track with that market’s performance. By buying an index fund, you’re buying a small slice of the entire market.
And similarly to ETFs, index funds tend to be passively managed: Since they mirror the market’s performance, you’re not concerned with beating the market, or picking out “winners” that will outperform the market’s annual growth. You’re just coasting along, benefiting from the market’s long-term growth and saving yourself the trouble of extensively researching and selecting individual stocks.
So if ETFs are basically a type of index fund, what’s the difference between the two? Well, read on…
The difference between index funds and ETFs
Both index funds and ETFs basically aim to track a specific market and are usually not actively managed—unlike most mutual funds—meaning that they don’t have such high fees associated with them, since a manager isn’t as actively involved.
Types of assets you can invest in
But one key difference between ETFs and index funds is that while index funds will always be tied to a specific market, ETFs can bundle together a wide variety of assets—even securities like gold, or renewable energies, or real estate, or industries in international markets.
With traditional index funds, however, you’re simply tracking the performance of a specific market, which includes all companies within that market. So if you wanted to focus more on energy but have an index fund that tracks the S&P 500, then you’re automatically investing in all companies in that market, regardless of whether you’re actually interested in them.
Trading times
Another difference is that exchange traded funds are traded like stock. This means that investors can trade shares throughout the day. Index funds, on the other hand, only trade once a day, after the market closes, which is when their price is set. So there’s a little bit less flexibility on when you can buy or sell shares.
Investing minimums and overall costs
Index funds–like mutual funds—tend to have pretty high investing minimums, meaning that they can be quite prohibitive for novice investors who don’t have loads of starting capital just sitting around. ETFs, on the other hand, tend to have low to no investment minimums.
And although both funds tend to be considered more budget-friendly than mutual funds because of their inherent passive investing style, index funds can still have higher management fees in comparison to ETFs, although you usually don’t have to pay transaction costs or commission when trading with index funds.
Choosing between index funds and ETFs
We’ve covered some differences between the two, but which one should you choose? There’s no simple answer. It all depends on what your investing goals are, what you’re comfortable risking and spending, and what your current financial situation is.
Index funds can be an appealing way for first-time, busy, and cautious investors as well as those on a budget to get started in their investing journey. But investing is not a one-size-fits-all type of thing, and index funds have certain characteristics that might not suit your goals.
Pros of index funds
Accessibility. Unlike certain mutual funds that require research and an expensive fund manager or financial advisor, an index fund lets you easily participate in a market of your choosing, and takes away the headache that comes from having to choose what stock you think will perform best.
By investing in index funds, you’re choosing a passive investment strategy that simply mirrors the market instead of constantly trying to beat it. The fact that ETFs aren’t trying to beat a market might have its benefits: A 2016 study by S&P Dow Jones Indices found that over the past 15 years, 92.15% of large-cap managers, 95.4% of mid-cap managers, and 93.21% of small-cap managers failed to meet their respective benchmarks. Some suggest that a strategy that mirrors market indexes instead of trying to beat them may achieve more consistent long-term results. That makes index funds an attractive choice for investors who don’t have the time, money, or energy to pay a fund manager and intricately research specific companies.
Low costs. Especially when compared to traditional mutual funds, index funds tend to have much lower fees. Like we mentioned, no active managing means less annual fees, and low to no trading commissions. So usually, maintaining a portfolio of index funds will usually run you 0.05% to 0.25% annually, while actively managed funds can charge 1% to 2%.
Cons of index funds
Low flexibility. For an investor who’s keen to have a say in where their money goes or likes experimenting with different kinds of assets, an index fund can be a real bummer. One of the traits of index funds that make them so appealing to passive investors also can make them pretty frustrating for investors who want to have more control over what companies do and don’t make it into their portfolio. For an investor who’s keen to invest in a new sector like cryptocurrency, being tied to an index can feel limiting. Similarly, if there are companies in the index whose business practices you don’t agree with, there’s not much you can do about it if you’re sticking to index funds.
Low reward. Index funds are usually considered to be rather low-risk in comparison to picking and choosing stocks that you think will beat the market. This is especially true if you hold on to index funds for long periods of time to ride out any inevitable market dips that may happen. However, that also means that you’re not going to be discovering the next Apple anytime soon, because the companies in an index tend to be established, consistent companies with a record of steady, if modest, growth.
ETFs have two big things going for them: low costs and flexible diversification. Since purchasing an ETF containing dozens, if not hundreds, of stocks, investing in an ETF will automatically diversify your investment over the purchase of one stock and you will be afforded some natural protection cushioning your investment from market volatility.
Pros of ETFs
Lower fees. Because ETFs are usually passively managed, they tend to have lower management expense ratios and low investment minimums. This makes them very accessible for newbies and the budget-conscious.
Great for beginners. Because ETFs are the go-to asset for robo-advisors thanks to their low-cost, low-risk strategy, novice investors can get started with ETFs and have the opportunity to enjoy access to more markets and asset types in a low-cost environment that’s calibrated to how comfortable you are with risk.
Robo-advisors work with an algorithm that develops a balanced and diversified portfolio for you based on certain information you’ve provided, and even automates regular investment deposits to ensure your money keeps growing. Apart from making this whole investment thing super easy, it also ensures that you can participate in various markets by automatically investing in a wide variety of ETFs, and also automatically rebalancing your portfolio if something changes. It’s like having a personal fund manager, at a fraction of the cost.
Cons of ETFs
Potentially more transaction costs. Depending on how you choose to invest in ETFs, you might be facing higher transaction costs and commissioning fees, since ETFs trade like stocks throughout the day. However, this is where investing with robo-advisors can really save you some money. Some robo-advisors don’t charge any commission, have low to no transaction costs, and no account minimums. Those factors can really make a difference when keeping your costs down.
Not conducive to short-term strategies. Because ETFs usually aim to mirror markets, you’re less likely to see benefits if you only hold assets for short amounts of time, such as five years or less. That also makes you more susceptible to market fluctuations. If you’re looking to access your funds in a shorter amount of time, then something like a high-interest savings account may be more appropriate.
Bottom line: If you’re looking for more flexibility and the chance to choose more freely when it comes to what kinds of assets you want to invest in, then ETFs might be more appealing to you. More conservative or cautious investors may prefer index funds to ETFs, while investors who want to benefit from exposure to more types of assets or want to take advantage of real-time pricings during the trading day may prefer ETFs. Ultimately, it all comes down to personal preference and financial goals.
