While most exchange-traded funds, or ETFs, are passively managed just like index funds (meaning they track a certain market index), these funds have different structures, which can have a significant impact on investors.
Index funds are a type of mutual fund, which means they are less transparent, liquid, and tax efficient compared with ETFs. Exchange-traded funds shares, for example, trade on exchanges throughout the day, similar to stocks — while index funds do not. Owing to disclosure regulations, index ETFs are also more transparent than index mutual funds.
Here’s what else you need to know before you decide whether to invest in an index fund vs. an ETF.
An Overview of Index Funds
In order to understand some of the similarities between index funds and ETFs, both of which adhere to passive investing strategies (though a small fraction of ETFs are actively managed), let’s start with what a market index is and how it works.
What Is an Index?
A market index tracks a representative sample of securities in a particular sector or asset class. For example, the S&P 500 index tracks the performance of the 500 largest companies in the U.S., while the Russell 2000 index tracks small-cap domestic companies. Typically, the index is weighted according to the size of the companies.
Most indices are used as benchmarks to measure the performance of assets in a particular sector. Meaning: large-cap U.S. mutual funds might measure their performance against the S&P 500 index as a benchmark.
You can’t invest in an index, but you can invest in funds that track the index.
So index funds or index ETFs that track the S&P 500 seek to mimic the performance of that benchmark by investing in the same large-cap U.S. companies that are in the index, and giving them a similar weight in the fund.
The same goes for funds that track any other benchmark, whether that’s the Nasdaq 100 Index (which includes 100 of the largest domestic and international non-financial companies), or the MSCI World Index (mid- and large-cap global companies), or one of the many bond indices. Index funds and ETFs simply track the performance of the index, thus they are passively managed.
What Is Passive Investing?
As noted above, an index fund mirrors the performance of its index, which is known as passive investing. An actively managed fund, however, follows the strategy of an active management team. So active investing is a strategy where human portfolio managers pick investments they believe will outperform the market — whereas passive investing relies on a formula to mirror the performance of certain market sectors.
There are thousands of mutual funds available to investors, and the vast majority of them rely on active strategies. In 2021, there were over 6,600 actively managed funds, and about 500 passively managed (index) funds in the U.S., according to Statista.
Even though the number of index funds is much smaller, these funds track a wide range of benchmarks, which naturally has an impact on index fund returns. A fund that tracks a corporate bond index versus a fund that tracks an index of biotech stocks will typically have different returns.
What’s the Differences Between an ETF and Index Fund?
When picking ETFs, however, bear in mind that the world of ETFs is the opposite of mutual funds: the majority of ETFs are passively managed; i.e. they are index ETFs.
Only about 2% of ETFs are actively managed, owing to rules about transparency for these products.
That’s why many actively managed ETFs rely on a certain fund structure that allows for less transparency. These are called active non-transparent or ANT ETFs.
So: ETF vs. index fund, what are the primary differences?
How an Index Fund Works
Index funds are mutual funds. They are a collection of stocks, bonds, or other securities that are bundled together into a single unit (the mutual fund). Some may invest in large-cap stocks; some in ESG companies; some in tech; some in international companies, and so on. Most investors own more than one type of mutual fund in their portfolio, and you can also own more than one type of index fund.
Like any other type of mutual fund, index fund shares can be traded only once per day. You can put in the order in the morning, but it won’t go through until the market closes. This means the price you anticipated when you entered the order to buy or sell isn’t necessarily what you’ll get.
💡 Recommended: Learn what actively managed ETFs are and how they work.
How an ETF Works
An ETF is an exchange-traded fund, so its wrapper — or structure — is not the same as a traditional mutual fund. While an exchange-traded fund is also a basket of securities, shares of these funds can be traded on exchanges throughout the day, just like stocks. As a result, ETF shares are not only more liquid from a cash standpoint, they are also more fluid.
Mutual fund shares vs. ETF shares are relatively fixed. ETFs can generate more shares, depending on investor demand. 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.
When trading ETFs, bear in mind that the expense ratio of ETFs is generally lower than most mutual funds. And owing to the way shares are created and redeemed, ETFs can be more tax efficient.
ETFs can offer that flexibility and more transparency: Investors can review holdings daily and monitor portfolio risk exposures more frequently than with indexed mutual funds.
Similarities Between ETFs and Index Funds
As noted above, ETFs and index funds are both pooled investments, like baskets that include dozens, sometimes hundreds of securities in a single package. This helps provide investors with diversification within the fund that can help mitigate risk and may improve performance. In addition, these two fund types share some other similarities.
Cost
ETF vs. index fund — which is cheaper? The cost per share varies widely, of course, but when it comes to expense ratios of these funds the two are increasingly competitive. Time was when ETFs fees were far lower, but now many index funds have ultra-low expense ratios.
Still, many ETFs no longer charge brokerage fees or commissions, which cuts out a cost that many mutual funds still charge. Mutual funds also tend to have higher administrative costs.
Diversification
Both ETFs and index funds can offer investors the potential to add diversification to their portfolios.
ETF vs Index Fund: Pros and Cons of Each
There’s no cut-and-dried answer to whether ETFs are better than index funds, but there are a number of pros and cons to consider for each type of fund.
Transparency
By law, mutual funds are required to disclose their holdings every quarter. This is a stark contrast with ETFs, which disclose their holdings each day.
Transparency may matter less when it comes to index funds, however, because index funds track an index, so the holdings are not in dispute. That said, many investors prefer the transparency of ETFs, whose holdings can be verified day to day.
Pricing
Because a mutual fund’s net asset value (NAV) isn’t determined until markets close, it can be hard to know exactly how much an index fund costs until end of day. That’s partly why mutual funds, including index funds, allow straight dollar amounts to be invested, as well as purchasing shares. If you buy an index fund at noon, you can buy $100 worth, for example, regardless of the share price.
ETF shares, which trade throughout the day like stocks, are priced by the share, so you always know how much you’re paying for an ETF.
This pricing structure also allows investors to use stop order or limit orders to set the price they’re willing to buy or sell.
Taxes
ETFs are generally considered more tax efficient than mutual funds, including index funds.
The way mutual funds are structured, there can be more tax implications as investors buy in and out of an index fund, and the cost of taxes is shared among different investors. ETF shares are redeemed directly for cash, so if there are capital gains, you would only owe them based on your ETF shares.
How Do Investors Find the Right ETF?
Choosing between ETFs vs. index funds typically comes down to cost and flexibility, as well as understanding the tax implications of the two fund types. While both ETFs and index funds are low-cost, passively managed funds — two factors which can provide an upside when it comes to long-term performance — ETFs generally have the upper hand when it comes to taxes.
If taxable gains are a concern for you, ETFs may be a more tax-efficient option vs. index funds, which are structured such that gains are dispersed among shareholders. Also consider the tax structure of the container: i.e. are you holding the fund in a taxable portfolio, or a tax-deferred retirement account?
Once your goals are clear, selecting an ETF is easy when you set up a brokerage account with SoFi Invest. You can explore ETFs from the secure SoFi app at your convenience, and invest in ETFs in a taxable account or an IRA. SoFi also enables you to trade stocks, IPO shares, and more. Whatever your aims are, SoFi can get you started on your investing future.
FAQ
Is it better to choose an ETF or an index fund?
ETFs and index funds each have their pros and cons. ETFs tend to cost less and be more tax efficient, and you can trade ETFs like stocks throughout the day. If you’re interested in more of a buy-and-hold strategy, an index fund may make more sense.
What are the similarities between an ETF and an index fund?
All index funds, and about 98% of ETFs, are passively managed — meaning, they track a certain market index. In addition, both ETFs and index funds tend to be much cheaper to own, versus their actively managed counterparts.
What are the differences between an ETF and an index fund?
ETFs generally cost less, are more transparent, and more tax efficient compared with index funds.
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Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.
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