What Are Index ETFs?

Index ETFs Explained

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Index ETFs are exchange-traded funds that aim to duplicate and track a benchmark index, like the S&P 500. Exchange-traded funds (ETFs) can be bought and sold on exchanges intraday (during normal trading hours), and they have some tax and cost advantages over mutual funds.

You can use index ETFs as a primary holding or to diversify a stock portfolio. Let’s go over how index ETFs work and look at some alternatives.

Definition and Examples of Index ETFs

Index exchange-traded funds (ETFs) are designed to track the performance of an underlying market index—such as the Dow Jones Industrial Average, the S&P 500, and the Russell 2000—or a targeted subset of the overall market. These funds allow individual investors to gain exposure to an entire index of stocks. Many of the largest ETFs are index ETFs.

An index ETF’s performance does not perfectly mirror the underlying index due to subtle variations in the value of the fund vs. the ETF’s market price.

Stock indexes are created to capture the performance of the whole market or a subset of it. The most commonly cited index is the S&P 500, but there are indexes for U.S. markets, overseas markets, specific sectors, and asset classes (i.e., large-cap or international stocks). Index ETFs aim to replicate the composition as well as the performance of such indexes. For example, the SPDR S&P 500 ETF (SPY) closely tracks the S&P 500. Launched in 1993, the SPY is the oldest U.S.-listed ETF—and one of the largest, too, with more than $400 billion in assets under management as of Sept. 8, 2021.

How Index ETFs Work

The underlying stock index that an index ETF is based on is often created and run by one company, then licensed to the ETF management company. The ETF prospectus will spell out how the index is created.

ETF managers strive to replicate an index’s performance by including the same holdings and trading decisions as the fund’s underlying index. Index ETFs trade actively on the market just like stocks. On some occasions, their net asset value (NAV) may differ from their trading price, but that does not last long.

Some of the most popular fund companies for ETFs include Vanguard, iShares, Invesco, and State Street Global Advisors.

An index ETF can be purchased in any online brokerage account simply by finding the ETF’s ticker symbol and submitting an order to buy shares online.

Index ETFs vs. Mutual Funds

In many aspects, ETFs are similar to mutual funds. Both rely on pools of money that are invested based on a goal or strategy expressed in the fund’s prospectus. Whereas most mutual funds are actively managed by a professional fund manager, most ETFs are passively managed (changing only when the asset allocation of the underlying index changes). 

Consider the differences between mutual funds and index ETFs before you decide which one is right for your portfolio.

Index ETFs Mutual Funds
Track composition of an index May track an index or a fund manager; may select underlying investments
Typically managed passively Can be actively or passively managed
Can be traded on an exchange at any time like stocks Can only be bought or sold once during the day
Tax on capital gains when you sell index ETF shares Capital gains distribution and tax liabilities can arise when the fund manager sells shares held by the fund
Cost less than mutual funds Typically cost more than ETFs

ETFs have a few advantages over mutual funds—one being that they trade intraday on an exchange instead of once per day after market close like mutual funds.

When you purchase an ETF, you are not directly purchasing it from the fund company. Rather, you are buying it from a third party known as an authorized participant (AP) who handles the buying and selling of the ETF’s underlying securities.

While buying an ETF isn’t a taxable event, you may pay capital gains taxes when you sell it. If you hold an ETF for less than a year, you may be subject to short-term capital gains taxes on any profits; after one year, your profits will be taxed at the long-term capital gains rate. Short-term capital gains are equal to your ordinary income tax rate, while long-term capital gains taxes can be taxed between 0-20%, depending on your taxable income. Contrast that with mutual fund holders, who pay capital gains taxes whenever the fund company sells a stock after holding it at a profit. 

Compared to mutual funds, investing in index ETFs may be a compelling prospect for investors looking to minimize the impact of taxes on their long-term gains.

Another advantage of index ETFs is their low cost. Index mutual fund costs have come down a lot over the past few decades or so. But some mutual funds still charge investors a fee just to buy the fund, called a front-end load—and a high annual fee on top of that. Many index ETFs have annual expense ratios (the percentage of the fund’s assets used for administrative and operating costs) in the single digits and no loads.

What They Mean for Individual Investors

Index ETFs offer a lot of flexibility for individual investors. You can:

  • Start a retirement account and invest it all in an S&P 500 ETF while reaping the long-term benefits and potential returns of a diversified stock portfolio.
  • Use index ETFs to create a smart asset allocation portfolio to diversify into different asset classes for better risk-adjusted returns.
  • Use non-traditional ETF index funds to invest based on value, quality, or your personal morals. 

The main alternative to index ETFs is index mutual funds. You’re likely familiar with these if you have ever made investment decisions in a 401(k), for example.

ETFs are generally superior to mutual funds for the reasons discussed above, including lower fees and better tax efficiency. However, if you’re stuck with index mutual funds in a 401(k) or a similar investing scenario, and you stick to smart investing principles, you’ll still be able to take advantage of their benefits over the long term.

Key Takeaways

  • Index exchange-traded funds (ETFs) invest a pool of money in an attempt to replicate the performance of an underlying index. 
  • Index ETFs trade on exchanges like stocks.
  • Generally, index ETFs have better fees and tax efficiency than mutual funds. 
  • You can use index ETFs for diversification and other strategies as an individual investor.