ETFs vs index funds: What’s the better investment? Learn the differences and similarities between them before deciding which one gets a spot in your investment portfolio.
5 min read
As you start your investing journey, one of the first things to do is decide what to invest in. Sounds simple, but then you realize how many options there are: not just stocks and real estate, but other investment vehicles like exchange-traded funds, index funds, and much more.Both exchange-traded funds (ETFs) and index funds are popular choices for people who want to grow their money without diving headfirst into stock trading. There are similarities between the two, but also some key distinctions that could impact which one is right for you. So, what’s the difference between ETFs and index funds?
How is an index fund different than an exchange-traded fund?
ETFs and index funds try to copy the performance of a specific market index, like the S&P 500 or the DAX. But they’re bought, sold, and managed differently, and these characteristics can influence which option best suits your investment style. Here are the main differences:
#1: Trading mechanism
Investors can buy or sell ETFs on the stock market throughout the trading day. That means that prices fluctuate based on supply and demand, just like individual stocks.Index funds operate more like traditional mutual funds, where trades are executed once a day. Regardless of when you place a buy or sell order during the day, it'll be processed after the market closes. And the price is set at whatever the fund’s value is at the end of the day — also called the closing price.
#2: Investment structure
ETFs are open-ended, meaning they can continuously create and redeem new shares through a process involving authorized participants. This keeps the market price closely aligned with the net asset value (NAV) of the underlying assets. This structure also gives ETFs more liquidity — i.e. they can be easier to buy and sell at short notice.Index funds are generally closed-ended, meaning there’s a fixed number of shares available. This doesn't affect daily trading as much, but it does limit liquidity. In certain market conditions, it can also sometimes cause a mismatch between the share prices and the value of the underlying assets.
#3: Tax implications
ETFs are known for being more tax-efficient, mainly because their structure includes a certain process for creating and redeeming shares in the fund. This structure helps minimize capital gains distributions, meaning investors are less likely to pay taxes on gains until they sell their shares.Because index funds have a different share structure than ETFs, they may distribute capital gains more frequently. This can result in higher tax liabilities for investors, especially in taxable accounts, even if the investor hasn’t sold their shares.
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When it comes to choosing investments, both ETFs and index funds tick some of the same boxes. Let’s take a look at what these two investment vehicles have in common:
Passive management: ETFs and index funds typically don’t rely on fund managers to hand-pick stocks or try to beat the market — so they’re appealing to investors who prefer a hands-off approach to investing.
Stability: Funds are usually good options for investors who want steady, long-term growth without the volatility or complexity of stock trading.
Diversification: With ETFs and index funds, you’re spreading your money across a wide range of assets — like stocks, bonds, or even commodities — so your overall risk is lower.
ETFs vs index funds: Choosing the right path for your portfolio
Differences and similarities aside, ETFs and index funds can both be good investment options. They’re relatively low-cost, lower risk, and diversified. To help you narrow down your choice, you can think about your personal preferences when it comes to things like:
Frequency: If you prefer having control over the exact timing of your trades, ETFs are the better option. For long-term, “set it and forget it” investors who are less concerned with what the markets are doing day to day, index funds can be simpler.
Taxes: If keeping your tax bill low is a priority, ETFs might be the better fit for your portfolio. While index funds are also tax-efficient, they can distribute capital gains more frequently than ETFs do. If you hold index funds outside of retirement accounts, think about the potential tax implications and how they could affect your investment returns over time.
If you’re looking for flexibility and tax efficiency, ETFs might be your best bet. But if you're focused on long-term, steady growth and prefer simplicity, index funds could be the way to go.
Different styles, similar benefits
ETFs and index funds can both be a simple, low-cost way to diversify your investment portfolio. Ultimately, the choice between them depends on your personal trading preferences and goals — the main benefits are the same. They give you access to a broad range of assets, all while keeping fees low and minimizing the need for constant management.Both paths lead to cost-effective diversification, so it’s really about finding what best suits your style and needs. Like all investments, they come with some risk, so make sure not to put in more money than you can afford to lose.
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FAQs
Yes, there are actively managed ETFs out there, too. Unlike typical ETFs, which passively track an index, actively managed ETFs have portfolio managers who make investment decisions to try to outperform the market.
Expense ratios for both ETFs and index funds are generally low, but ETFs often have slightly lower expense ratios. However, specific costs can vary based on the fund, so it's important to check and compare.
Yes, you can invest in both ETFs and index funds within the same portfolio. This could give you some of the best of both: trading flexibility thanks to ETFs, and a long-term, hands-off strategy with index funds.
The main risks with ETFs and index funds include market risk, where the value of the underlying assets can decline. Since both track broad indexes, they’re vulnerable to general market downturns. And depending on their focus, specific ETFs may have liquidity risks or be heavily concentrated in one sector.
To choose the right ETF or index fund, first define your investment goals. Assess your risk tolerance to ensure you’re comfortable with any ups and downs in the market. Compare expense ratios to find low-cost options, and research the underlying assets to ensure they align with your strategy and values. Finally, look at how well the fund has performed in the past and how closely it matches the index that it tracks. Metrics like a fund’s tracking error can help you evaluate its success rate.
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