There are strengths, weaknesses, and best-use strategies for both index funds and exchange-traded funds (ETFs). They're similar in a lot of ways, and the terms are used interchangeably by some, but "index funds" typically refer to indexed mutual funds, while "ETFs" can refer to any type of ETF without regard to its holdings, goals, or fee structure.
Keep reading to learn more about how these products differ from each other and which could be right for you.
What's the Difference Between ETFs and Index Funds?
|Fund management style||Can be active or passive||Passive|
|Expense Ratios||Lower than mutual funds||Higher than indexed ETFs (though lower than active funds)|
|Price||Determined by trading throughout the day||Determined by NAV|
Fund Management Style
While ETFs can come in a wide variety of styles, both index funds and index ETFs fall under the heading of "indexing." Both involve investing in an underlying benchmark index. The primary reason for indexing is that index funds (both index ETFs and index mutual funds) can often beat actively managed funds in the long run.
Unlike actively managed funds, indexing relies on what the investment industry refers to as a passive investing strategy. Passive investments are not designed to outperform the market or a particular benchmark index, and this removes manager risk—the risk or inevitable eventuality that a money manager will make a mistake and end up losing to a benchmark index.
A top-performing actively managed fund might do well in the first few years. It achieves above-average returns, which attracts more investors. Then the assets of the fund grow too large to manage as well as they were managed in the past, and returns begin to shift from above-average to below-average.
By the time most investors discover a top-performing active fund, they've missed the above-average returns. You rarely capture the best returns because you've invested based primarily on past performance.
Passive investments such as index mutual funds and indexed ETFs have extremely low expense ratios compared to actively managed funds. This is another hurdle for the active manager to overcome, and it's difficult to do consistently over time.
Many index funds have expense ratios below 0.20%, and indexed ETFs can have expense ratios even lower, such as 0.10%. Actively managed funds often have expense ratios closer to 1%.
A passive fund can have a 1% or more advantage over actively managed mutual funds before the investing period begins, and lower expenses often translate to higher returns over time.
Lower expense ratios can provide a slight edge in returns over index funds for an investor, at least in theory. ETFs can have higher trading costs, however, depending on the brokerage you use.
The primary difference between these two terms is that "index funds" are typically mutual funds, and ETFs are traded like stocks, not mutual funds. This has an impact on the price you pay for the investment.
The price at which you might buy or sell a mutual fund isn't really a price—it's the net asset value (NAV) of the underlying securities. No matter when you place your trade during the day, your trade executes at the fund's NAV at the end of the trading day. If the prices of the securities held within the mutual fund rise or fall during the day, you have no control over the timing of execution of the trade. You get what you get at the end of the day, for better or worse.
ETF traders have the ability to place stock orders. This can help overcome some of the behavioral and pricing risks of day trading. An investor can choose a price at which a trade is executed with a limit order. They can choose a price below the current price and prevent a loss below that chosen price with a stop order. Investors don't have this type of flexible control with mutual funds.
However, since ETF trading is determined by price action rather than NAV, it is possible to pay more for an ETF than the total value of assets held within the ETF. The price of the ETF generally tracks close to the underlying value of securities, but it may not always exactly match.
Which Is Best For You?
ETFs and index funds are similar, but the best option for you will likely come down to trading style.
ETFs May Be Best For You If...
ETFs trade intra-day, like stocks. This can be an advantage if you're able to take advantage of price movements that occur during the day.
You can buy an ETF early in the trading day and capture its positive movement if you believe the market is moving higher and you want to take advantage of that trend. The market can move higher or lower by as much as 1% or more on some days. This presents both risk and opportunity, depending on your accuracy in predicting the trend.
Index Funds May Be Best For You If...
If you don't care about trying to seize upon every opportunity the trading day presents, then you may be best off with index funds. Trading ETFs without learning the ins and outs of how trades work can leave you vulnerable to extra costs.
Part of the tradable aspect of ETFs is the "spread," the difference between the bid and ask price of a security. When ETFs aren't widely traded, the spread becomes wider and the costs of the spread become larger.
Jack Bogle, founder of Vanguard Investments and the pioneer of indexing, had his doubts about ETFs, although Vanguard has a large selection of them. Bogle warned that the popularity of ETFs is largely attributed to marketing by the financial industry. The popularity of ETFs might not be directly correlated to their practicality.
The ability to trade an index like stocks also creates a temptation to trade, which can encourage potentially damaging investing behaviors such as poor market timing and frequent trading increases expenses.
A Best-Of-Both Worlds Option
The index funds vs. ETF debate doesn't have to be an either/or question. It can be smart to consider both.
Fees and expenses are the enemies of the index investor, so the first consideration when choosing between the two is typically the expense ratio. There might also be some investment types where one fund has an advantage over another. An investor who wants to buy an index that closely mirrors the price movement of gold, for instance, will likely best achieve their goal by using the ETF called SPDR Gold Shares (GLD).
Finally, although past performance is no guarantee of future results, historical returns can reveal an index fund or ETF's ability to closely track the underlying index and thus provide an investor with greater potential returns in the future.
The Bottom Line
Choosing between index funds and ETFs is a matter of selecting the appropriate tool for the job. ETFs may offer lower expense ratios and greater flexibility, while index funds simplify a lot of the trading decisions an investor has to make.
An investor can wisely use both. You might choose to use an index mutual fund as a core holding and add ETFs that invest in sectors as satellite holdings to add diversity. Using investment tools for the appropriate purpose can create a synergistic effect where the whole portfolio is greater than the sum of its parts.
Frequently Asked Questions (FAQs)
What is a leveraged ETF?
While a standard ETF holds shares in the companies that make up the underlying index, a leveraged ETF holds derivatives that amplify the volatility of the index. For instance, QQQ is a popular ETF that tracks the biggest companies on the Nasdaq. TQQQ is a leveraged ETF that tracks the same companies but with three times the volatility. Leveraged ETFs can also be inverse, which means that they move in the opposite direction of the underlying index.
How do ETF dividends work?
From an investor's standpoint, ETF dividends are just the same as any other stock dividend. The ETF manager will collect dividends from companies throughout the quarter and then distribute them to ETF holders after accounting for any fees.
What is the SPY ETF?
The SPDR S&P 500 ETF Trust, which trades by the ticker "SPY," was the first ETF introduced to the market. It remains one of the most actively traded ETFs to this day—if not the most actively traded. It tracks the S&P 500 index and is often referenced as a gauge of the overall stock market.
How do you know which index fund to buy?
The best index fund for you depends on what your investment goals are. If you need to add stock market exposure, you could use a broad market fund like the Fidelity 500 Index Fund (FXAIX) or the Schwab S&P 500 Index Fund (SWPPX). If you need to add bond exposure, you could use a fund that focuses on bonds, like the Vanguard Long-Term Investment Grade Fund (VWESX) or the Vanguard Total Bond Market Fund (VBTLX).
How do you track the Russell 2000 with an index fund?
The Russell 2000 is an index that tracks small-cap companies. You can invest in it with index funds like the Fidelity Small-Cap Index Fund (FSSNX) and the Schwab Small-Cap Index Fund (SWSSX).