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

Index Fund vs. ETF: An Overview

Index funds and exchange-traded funds (ETFs) have revolutionized investing over the past few decades, offering low-cost ways for individuals to gain broad market exposure. While these two investment vehicles share many similarities, they also have key differences that investors should understand.

"By taking a passive, index-based investment approach, an investor can keep fees low while diversifying the portfolio across industries, sectors, and geographies. This results in the investor approximating “universal ownership”—that is, owning a representative slice of the entire global economy—and positioning herself to benefit from broad economic growth regardless of the fortunes of individual companies," David Tenerelli, a certified financial planner at Strategic Financial Planning in Plano, Texas, told us.

Index funds are a broad category that includes both passively managed mutual funds and ETFs. As it happens, the majority of both types of funds are index funds. However, the costs, tax implications, and trading opportunities differ between mutual funds and ETFs. Below, we take you through these differences so you understand these important and, for many, fundamental portfolio investments.

What Are Index Funds?

Passive investing through index funds has seen tremendous growth in recent years as investors seek low-cost, diversified options to build their portfolios. Index funds track the performance of a specific market index, such as the S&P 500 for large U.S. stocks or the Bloomberg U.S. Aggregate Bond Index for U.S. bonds.

The appeal of index funds lies in their simplicity and cost-effectiveness. "Because there's no original strategy, not much active management is required and so index funds have a lower cost structure than typical mutual funds," said Will Thomas, a certified financial planner at the Liberty Group in Washington, DC. By mirroring an index rather than trying to outperform it, these funds have expenses far lower. This and their generally good performance has led to their growing popularity. As of year-end 2023, index mutual funds and ETFs accounted for 48% of assets in long-term funds, up significantly from 19% at year-end 2010.

Index mutual funds are priced once daily after the market closes, and investors buy or sell shares directly from the fund company. In contrast, Thomas noted, "Although they also hold a basket of assets, ETFs are more akin to equities than to mutual funds. Listed on market exchanges just like individual stocks, they are highly liquid: They can be bought and sold like stock shares throughout the trading day, with prices fluctuating constantly."

Index Mutual Funds

Index mutual funds have revolutionized investing since their introduction in the 1970s, offering a low-cost way for investors to gain broad market exposure. These funds aim to replicate the performance of a specific market index, such as the S&P 500 for large U.S. stocks or the Bloomberg U.S. Aggregate Bond Index for bonds. Here are some of their key features:

• Broad diversification: Most index funds provide exposure to hundreds or thousands of securities in a single financial product, offering instant diversification.
• Low expenses: With no need for extensive research teams or frequent trading, index funds generally have lower expense ratios than their actively managed counterparts. At year-end 2023, the asset-weighted average expense ratio for index equity mutual funds was 0.06%, compared to 0.66% for actively managed equity mutual funds.
• Passive management: Unlike actively managed funds, index funds simply track their target index rather than outperform it.
• Predictability: While index funds won't outperform their benchmark, they also won't significantly underperform (before fees), providing more predictable returns.
• Tax efficiency: Lower portfolio turnover in index funds can result in fewer taxable events for investors holding these funds in taxable accounts.
  

The popularity of index mutual funds has grown significantly over the past decade. As of year-end 2023, index mutual funds held $5.9 trillion in total net assets, representing 30% of long-term mutual fund assets. This growth reflects increasing investor awareness of the impact of fees on long-term returns and skepticism about the ability of active managers to consistently outperform their benchmarks.

However, index funds are not without risks. They will fall in value when their target index declines, and they may underperform actively managed funds during certain market conditions. In addition, not all indexes are created equal, and some may be more representative of their target market than others.

Exchange-Traded Funds (ETFs)

ETFs are funds that trade on stock exchanges, much like individual stocks. They offer investors a way to buy a basket of securities in a single transaction. ETFs can track various assets, including stocks, bonds, commodities, or currencies, and can be both actively and passively managed. They account for about 30% of all trading in the U.S.

Here are some of the essential features of ETFs:

• Intraday trading: Unlike mutual funds, ETFs can be bought and sold throughout the trading day at market prices.
• Transparency: Most ETFs disclose their holdings daily.
• Tax efficiency: ETFs often generate fewer capital gains due to their structure and lower turnover.
• Lower minimum investments: Investors can often buy as few as one share.
  

Index ETFs

Index ETFs were the first type of ETFs to begin trading in the early 1990s in the U.S. They track the performance of a specific market index and run like index mutual funds but with the added benefits of ETF structures.

Here are the essential aspects of index ETFs:

• Passive management: They aim to replicate the performance of their target index.
• Low cost: With minimal active management, they typically have lower expense ratios.
• Diversification: They provide exposure to all securities in their target index.
• Liquidity: They can be traded throughout the day, potentially offering more liquidity than index mutual funds.

Index ETFs have seen substantial growth, with total net assets reaching $5.4 trillion at year-end 2023, representing a significant part of the ETF market.

Key Differences

The significant difference between index funds and ETFs is how you buy shares in them and their flexibility. Index mutual funds can only be bought and sold at the end of the trading day, based on the fund's net asset value (NAV). ETFs trade throughout the day on a stock exchange, just like stocks, and their price fluctuates based on supply and demand.

What this means is that with index mutual funds, your trades are priced at the end of the day based on the total value of the fund's holdings at that time. But with ETFs, your price reflects real-time supply and demand.

They also differ in cost. There are typically no shareholder transaction costs for mutual funds. Management fees tend to be lower for ETFs.

Index ETFs tend to be more tax-efficient than index mutual funds because of how they are structured. ETFs generally use an "in-kind" creation and redemption process, which minimizes capital gains distributions that would otherwise trigger tax events. Meanwhile, mutual funds may generate capital gains when the fund manager has to sell holdings to meet redemptions, potentially leading to a tax liability for investors even if they haven't sold their shares.

Another distinction lies in investment minimums and transaction costs. Index mutual funds often have a minimum investment requirement, which can be a barrier for some investors, though these are typically dropped if you are investing through your paycheck. Index ETFs, meanwhile, typically do not have minimums, as you can purchase as little as one share, making them more accessible. However, while ETFs might offer lower expense ratios than mutual funds, buying and selling them could incur trading fees depending on your brokerage. In contrast, many index mutual funds can be bought directly from the issuer without commissions.

Liquidity also distinguishes index funds from ETFs. Since index mutual funds are bought and sold at the end of the trading day, liquidity is not as readily available as with 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.