Table of Contents
The main difference between exchange-traded funds (ETFs) vs. index funds concerns how each type of fund is structured. Index funds, like many mutual funds, are open-end funds with a portfolio based on a basket of securities (e.g. stocks and bonds). Fund shares are priced once at the end of the trading day, based on the fund’s net asset value (NAV).
An ETF, on the other hand, is a type of investment fund that also includes a basket of securities, but shares of the fund are designed to be traded throughout the day on an exchange, similar to stocks. For clarity, index funds are designed to try and track a specific market index, whereas ETFs are a type of fund structure, and they can be passively or actively managed. Index mutual funds (which can be referred to as index mutual funds), then, can also be funds that are designed to track an index.
Key Points
• ETFs and index funds both offer investors exposure to a basket of securities, which may provide portfolio diversification.
• ETFs can be traded throughout the day, while index mutual funds are traded at the end of the day.
• ETFs typically disclose their holdings daily, whereas index funds disclose quarterly.
• ETFs tend to have higher expense ratios than index funds, but can offer more trading flexibility.
• ETFs are generally more tax efficient than index funds.
What Are Index Funds?
Index funds (or index mutual funds) are a type of mutual fund or ETF. Like other mutual funds, an index fund portfolio generally comprises a collection of stocks, bonds, or other securities that are bundled together into a pooled investment fund.
Passive Management in Index Funds
Unlike most other types of mutual funds, which are actively managed by a portfolio manager, index funds are designed to mirror the holdings and the performance of an index like the S&P 500 index of U.S. large-cap stocks, or the Russell 2000 index of small-cap stocks.
Index funds are generally passively managed, and as a result, they tend to have lower costs than other types of mutual funds.
Index Fund Liquidity Constraints
Liquidity constraints may be of concern to some investors when it comes to index funds. Investors buy shares of the fund, which gives them exposure to the basket of securities within the fund. As noted above, index mutual fund trades can only be executed once per day, which makes them less liquid than ETFs.
In addition, index funds (and mutual funds in general) reveal their holdings every quarter, so they tend to be less transparent than ETFs, which typically reveal their holdings once a day.
As a plus, though, there are thousands of indexes to choose from, and it’s possible to create an investing portfolio from index funds alone.
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What Are ETFs?
Unlike index mutual funds, ETF shares can be traded on exchanges throughout the day, just like stocks. ETFs can also be designed to track an index. Accordingly, ETFs require a different structure than traditional index mutual funds.
ETF Costs
When trading ETFs, bear in mind that the average expense ratio of ETFs is around 0.15%, which is historically low – but still higher than most index mutual funds, which have an average expense ratio of 0.05%.
Depending on the brokerage involved, investors may also pay commissions and a bid-ask spread, which is the difference between the ask price and the bid price of an ETF share, although this has less of an impact for buy-and-hold investors.
ETFs and Tax Efficiency
Due to the way ETF shares are created and redeemed, ETFs may be more tax efficient than index funds. When investors sell shares of an index fund, the underlying securities in the fund must be sold, and if there is a capital gain it’s passed onto all the fund shareholders.
When an investor sells shares of an ETF, the fund doesn’t incur capital gains, owing to the mechanism for redeeming shares. But if the investor sees a profit from the sale, this would result in capital gains (which is also true when selling index fund shares), which has specific tax implications.
Of course, investors who hold ETFs or index funds within an IRA or other retirement account would not be subject to capital gains tax events. It may be a good idea to speak with a financial professional for guidance to get a sense of exactly what type of tax liabilities you may be looking at.
When picking ETFs, however, bear in mind that the majority of ETFs are passively managed: i.e. they are index ETFs. Only about 9% of ETFs were actively managed at the end of 2024, a big increase from previous years, owing to the complexity of their structure and industry rules about transparency for these funds.
Key Differences: ETF vs. Index Fund
When comparing ETFs vs. index funds, there are a few similarities:
• Both types of funds include a basket of securities that can include stocks, bonds, and other securities.
• ETFs and index funds may provide some degree of portfolio diversification.
• Index funds and most ETFs are usually considered passive investments because they often mirror the constituents of a benchmark index. (By comparison, actively managed mutual funds and active ETFs have a live portfolio manager who oversees the fund, and makes trades with the goal of outperformance.)
Minimum Investments
Further, there may be minimum investments in the mix that investors should know about. ETFs don’t generally have minimum investments, but some index mutual funds do set minimums. That’s not to say that all do, and some may have very small minimums, such as $1. But it’s something to be aware of.
Trading Flexibility
As noted, ETFs may be a bit more easier to trade compared to index mutual funds, since they can be bought or sold at any time during the day. That may not be the same case for mutual funds. In other words, the two asset types have different levels of liquidity.
This chart helps to summarize the similarities and differences between ETFs vs index funds.
| ETFs | Index Funds |
|---|---|
| Similarities: | |
| Portfolio consists of many securities | Portfolio consists of many securities |
| Portfolio consists of many securities | Portfolio consists of many securities |
| Provides diversification via exposure to different asset classes | Provides diversification via exposure to different asset classes |
| ETF expense ratios are generally low | Index fund expense ratios are generally low |
| Most ETFs are passively managed | Index funds are passively managed |
| Differences: | |
| A special creation-redemption mechanism enables intraday share trading | Shares bought and sold/redeemed via the fund itself |
| Shares trade during market hours on an exchange | Trades executed at end of day |
| Fund holdings disclosed daily | Fund holdings disclosed quarterly |
| Shares are more liquid | Shares are less liquid |
| Investors may also pay a commission on trades or other fees | Investors may pay a sales load or other fees |
| ETFs tend to be more tax efficient | Index funds may be less tax efficient |
ETF vs. Index Fund: Which Is Right for You?
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.
When to Choose an ETF
ETF shares, which trade throughout the day like stocks, are priced by the share like stocks as well. Knowing stock market basics can help you invest in ETFs, as well. If you have $100 and the ETF is $50 per share when you place the trade, you can buy two shares.
This ETF pricing structure also allows investors to use stop orders or limit orders to set the price at which they’re willing to buy or sell. These types of orders, which are different from standard market orders, can also be executed through an online investing platform or by calling a broker.
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 differently, so if there are capital gains, you would only owe them based on your ETF shares.
So, if liquidity and tax efficiency is important to you, ETFs may be a good option.
When to Choose an Index Fund
By law, mutual funds are required to disclose their holdings every quarter. This is a stark contrast with ETFs, which typically 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.
Because a mutual fund’s net asset value (NAV) isn’t determined until markets close, it can be hard to know exactly how much shares of an index fund cost until the end of the trading day. That’s partly why mutual funds, including index funds, allow straight dollar amounts to be invested. If you buy an index fund at noon, you can buy $100 worth, for example, regardless of the price per share.
Given all that, mutual funds can also be a wise investment depending on your preferences and strategy.
The Takeaway
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 can have the upper hand when it comes to taxes.
As always, you should consider your strategy and goals when deciding how to invest. It may be a good idea to speak with a financial professional for guidance as well.
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FAQ
Is it better to hold an ETF or index fund long-term?
It is not necessarily better to invest in an index fund or an ETF over the long term, but rather, to invest in the vehicle that best aligns with your goals and strategy. Each type of investment has its pros and cons, so it’s a good idea to research each before making a decision.
Can an ETF also be an index fund?
It’s theoretically possible that an index fund could be an ETF. That would take the form of an ETF that tracks a specific index, like an index fund, and functionally bundle the same investments within it.
Are ETFs or index funds better for beginners?
Neither is particularly better for beginners, but both may be an option for beginners as they are are typically passively managed.
Do index funds pay dividends like ETFs?
Some index funds pay dividends, and some ETFs do as well. It depends on the specific fund in both cases, however.
Which has lower fees: ETFs or index funds?
Index funds, as mutual funds, tend to have higher fees or associated costs compared to ETFs.
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