ETFs vs. Index Funds

March 23, 2020 · 7 minute read

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ETFs vs. Index Funds

Understanding all the tools, terms, and strategies used by the financial industry can get complicated—especially for someone who is just starting to build an investment portfolio.

Even the essentials, like the differences between exchange-traded funds (ETFs) and other index funds, can be hard to follow.

You may have heard financial pundits discussing the benefits of ETFs more often in the past few years. That’s because they’re growing in popularity, thanks to some key features that other investing opportunities—including mutual funds—don’t offer.

They’re traded differently, for one thing, and, in some cases, are actively managed instead of passively following a market index. And the costs and risks can vary, depending on what kind of ETF it is or who is offering the fund.

If all that has you feeling a little lost, fear not. Here’s a breakdown of some basics.

What Is an Index?

In the financial world, an index gauges market performance. Instead of following every single security that trades in the United States and elsewhere, an index tracks a representative sample of the market.

Benchmark indexes have been created across all types of asset classes, including stocks, bonds, commodities, and currencies. For example, the S&P 500® Index tracks the stocks of 500 of the leading companies in the United States.

The Russell 2000® Index follows smaller, publicly traded companies. The Nasdaq-100® Index includes 100 of the largest domestic and international non-financial companies.

One way to determine how an investment or group of investments is doing is to compare it to an index that represents similar securities . An index can also be used to determine if an investment manager is outperforming or underperforming with his or her picks.

What Is an Index Fund?

Any investment fund that seeks to track an index is an index fund, whether it’s an ETF or a mutual fund. An index fund is created by a financial firm to mirror the performance of a specific index. S&P 500 Index funds, for example, seek to mimic the performance of that benchmark index by investing in S&P 500 companies with similar weights.

Traditional index funds use what is known as passive investment strategy, or a buy and hold strategy, which means fund managers don’t make active decisions about choosing stocks and market timing.

Index funds are popular with investors (including Warren Buffett ) who believe passive investing mitigates manager risk and investor emotion.

Instead of beating the market, they’re meant to track it, which is just fine for many investors. It turns out that many active managers can’t even match the performance of their benchmarks, so why try?

How Do ETFs Differ from Other Index Funds?

Much like a traditional mutual fund (with which most investors are more familiar), an ETF is a basket of different investments brought together as a single unit.

By pooling their money with others into a fund, investors can buy into a collection of securities they might not be able to afford or manage on their own. Each share gives its owner a stake in the fund’s assets, and access to a diversified asset allocation relative to a single share of a company.

Recommended: ETF Trading Guide: What to Know About Investing in Exchange Traded Funds

There are broad-market ETFs, sector ETFs, dividend ETFs, commodity ETFs, bond ETFs, and more. And ETFs can offer opportunities to invest in alternative investments that might otherwise be difficult for a retail investor to access.

Also, because one fund could include dozens, hundreds, or even thousands of individual stocks or bonds, it can be less risky than investing in a single security. The ETF’s value is based on that entire collection of assets : If one stock or bond in the fund is doing poorly, there’s a chance that others are doing well.

Because you don’t have to have a lot of money to own ETFs —the expense ratio is generally low and there’s typically no required minimum to invest—they can be a good entry vehicle for new and, especially, young investors. According to the 2018 ETF Investor Study by Charles Schwab & Co. Inc. , ETFs are the investment vehicle of choice for 91% of millennial investors.

Millennials in the study said 42% of their portfolios were currently in ETFs, and more than half (56%) said they already had replaced all individual securities in their portfolios with ETFs. Nearly 80% of millennials said they saw ETFs as their primary investment vehicle in the future.

Besides cost and access, there are some other features that set ETF index funds apart from other funds, including how they’re created and redeemed and the tax implications. But probably the most notable difference between ETFs and most other index funds is what happens when you want to trade shares.

With index mutual funds, you can only buy and sell shares as of the close of regular trading on weekdays. You can put in the order in the morning, but it won’t go through until the market closes. Which means the price you anticipated when you entered the order to buy or sell isn’t necessarily what you’ll get.

But because an ETF is listed on a stock exchange, a sale can go through any time the market is open. An investor can get real-time pricing information with relative ease by checking financial websites or calling a broker.

That’s a plus for investors and financial professionals who like the idea of making moves based on market conditions.

Some investors want to be more active. They want to trade during market hours to implement a strategy, or they want a manager who can take a more active role. ETFs can offer that flexibility and, at the same time, more transparency: Investors can review holdings daily and monitor portfolio risk exposures more frequently than with indexed mutual funds.

How Does an Actively Managed Fund Work?

While passively managed ETFs stick to a chosen index, actively managed funds typically employ a professional money manager (or management team) who is allowed to shift allocations to more appropriate sectors, companies, or asset classes based on market conditions.

The idea is that, with knowledge, experience, and intuition, it’s possible to analyze investment options and build and maintain a portfolio that can outperform an index. That’s the hope at least.

Sometimes, active management is about attempting to make more money. Sometimes, it’s about trying to lose less. While some actively managed funds may underperform in a bull market, during a bear market, they may redeem themselves by protecting their clients and managing risk.

Unfortunately, that hand-holding can come at a cost. The general knock on actively managed funds, including actively-managed ETFs, is that they tend to have higher fees . These higher fees tend to weigh on performance over time.

Is it Possible to Have Both Active and Passive Management?

Yes. Both active and passive management styles can have important roles to play in investing, and they have the potential to work well when combined .

Active management can help investors navigate complex concepts, build a more customized portfolio, and profit from market inefficiencies. Passive management can make investing more accessible and reduce costs. Many financial professionals use both strategies to effectively manage risk and help investors meet their specific financial goals.

By blending characteristics of both passive and active investing, investors with hybrid, smart beta ETFs retain many of the benefits of a buy-and-hold strategy while also attempting to improve returns with alternative indexing methods. Here’s how that works:

Most traditional indexes allocate to companies proportionately based on the company’s size. For example, a $10b company would have 2x the allocation of a $5b company. Smart Beta funds also looks at alternative factors as well, such as volatility, liquidity, value, or size. Each fund has its own rules for how it picks the stocks to be included.

Most of the largest U.S.-listed ETFs are benchmarked to traditional market capitalization-weighted indices, such as the S&P 500.

Those indexes use market capitalization (calculated by multiplying a company’s current share price by the total number of shares outstanding) to determine a company’s value at any given moment, instead of sales or total asset figures. So companies whose shares account for the largest market value have a larger weighting in the index.

That means those indexes tend to lean more toward big companies and sectors that have had success in the past, but they might not include those that could perform well in the future.

Market-cap weighted indexes typically do well in momentum-driven markets. (Rising prices tend to attract buyers, while dropping prices tend to attract sellers.) But they can become vulnerable in a down market.

In response, alternative indexing methods have taken hold over the past decade or so.

Equal-weighted indexing, for example, assigns the same weighting to large-, mid- and small-cap stocks. This approach can prevent the largest stocks from dominating a portfolio and may reduce the impact an underperforming stock or group of stocks might have.

Low-volatility indexes only include stocks with the lowest volatility. They focus on stability and attempt to avoid major price swings.

And fundamentally-weighted indexes look at various combinations of fundamental factors when selecting stocks. Using those factors, which are based on current and quantitative data, a company is assigned a score that determines its weighting in the index.

SoFi’s Select 500 ETF, for example, is linked to the Solactive SoFi US Growth Index, which is composed of the 500 largest publicly-traded companies.

Each stock in the fund is assigned a factor score that is calculated with three growth signals – top-line revenue growth and net-income growth over the past year, and 12-month forward-looking consensus estimates of net income growth. Stocks with higher growth scores receive a larger weight, and those with lower scores have a smaller weight.

Investors who want to diversify their portfolio see alternative indexing as a way to add investments that have the potential to behave differently as the market evolves.

A rules-based methodology may help limit market risk in a volatile market. And, according to the Schwab ETF study , that’s part of the draw for millennials and others.

Automated rebalancing, which both passive and active funds may offer, also can help keep the asset allocation you wanted in place and is a systematic way of selling high and buying low. (Although, of course, no investment is without risk.)

How Do Investors Find the Right ETF?

Considering how many ETFs are on the market, it should be possible to find one that suits your investing style. But if you aren’t sure, you can always get help.

With the SoFi Invest® online trading platform, you can enjoy the low-cost benefits of investing in an ETF, but there’s still a human advisor available—at no extra cost—to answer questions and assist in putting together a portfolio that can help you work toward your goals.

You can trade stocks and ETFs yourself with active investing, or, if you prefer, you can let SoFi Invest build a portfolio for your long-term goals with automated investing. Or you can do both.

Intelligently weighted and affordably priced, SoFi Invest’s smart beta ETFs offer a practical way to diversify a portfolio., SoFi ETFs weigh companies by growth—not just market capitalization. And they’re auto-rebalanced, so faster-growing companies are always in the mix.

If you hadn’t considered adding ETFs to your portfolio because the concept is new to you or you weren’t sure they’re a fit, check out what SoFi has to offer.

Looking to build a low-cost, diversified portfolio designed to get you to your financial goals? Download the SoFi app to get started.

External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
Third-Party Brand Mentions: No brands or products mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
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