One of the best ways to build wealth over time is to invest. Choosing individual stocks, though, can feel like a daunting task. If you want to start investing but are concerned about individual equities, one way to get instant diversification is to invest in an exchange-traded fund (ETF) or buy shares of an index mutual fund.
But what are the differences between these two investments? And which is the smarter choice for your investment goals?
Let’s look at how an ETF versus index fund stacks up and what you need to know before investing your money.
ETFs vs. index funds
ETFs and index funds can make it a little easier when investing money. Here’s a quick overview of an ETF versus an index fund.
|Objective||Depends on the ETF goals, whether tracking an index, generating income, or producing growth||Track the returns of a specific market index|
|Assets||Stocks, bonds, real estate, commodities, currencies||Usually stocks or bonds|
|Management style||Can be passive or active investment||Passive investment|
|Expense ratio||Average of 0.19%||Average of 0.06%|
What is an ETF?
An ETF is a pooled investment product offering exposure to multiple investments at once, similar to a mutual fund. However, unlike a mutual fund, an ETF can be traded on an exchange like a stock.
When you invest in an ETF, it’s important to note that you aren’t actually buying or selling the underlying assets. Instead, you’re buying a unit of the ETF, and only certain participants have access to the underlying basket of the assets.
What is an index fund?
An index fund is a type of mutual fund. With an index fund you’re buying shares of all the underlying investments.
However, the index fund tracks a specific index, usually a stock or bond index, and bases its holdings on what’s listed on that index. For example, an index fund that tracks the S&P 500 index will include shares of every stock that’s listed on that index, or a representative example of all those stocks.
The Dow Jones Industrial Average is another benchmark index you might be familiar with that some funds choose to follow.
Key differences between an ETF vs. index fund
Even though an ETF and index fund can look similar at first glance, the reality is there are some key differences. Here are some things to consider as you move forward with your investing strategy.
1. How they’re bought and sold
First of all, shares of an index fund are settled once per trading day, usually after the market closes. Investors can buy and sell their shares directly from the mutual fund, usually with the help of a broker.
You can place an order for shares of an index fund, but you won’t actually know the full purchase price until after the end of the day when everything has settled out, and the mutual fund has a chance to calculate its net asset value. The NAV is the total value of all the shares in the index fund, minus the liabilities held by the fund.
On the other hand, ETFs trade like stocks and can be traded throughout the day. An ETF is created in large blocks of in-kind deposits from “authorized participants.” These participants, often banks or large broker-dealers, receive shares of the ETF in exchange for deposits of their own investment assets.
Once they have these shares, these participants can then head to the exchange and sell them to investors. When an ETF share is on the exchange, it can be bought and sold intraday just like any other stock.
2. Minimum investment required
Depending on your brokerage account, there might be an investment minimum required to move forward with an index mutual fund or an ETF. For example, Vanguard requires a $3,000 minimum investment in most of its Admiral Shares index mutual funds.
On the other hand, it’s usually possible to purchase ETF shares from brokers without worrying about meeting a minimum. As long as the broker doesn’t have a minimum deposit to open an account, you can usually buy and sell ETF shares.
3. Capital gains taxes
When you realize a gain on an investment, you’re expected to pay taxes on that gain. However, one thing to understand is that ETFs are typically considered more tax-efficient.
Part of this is due to the way mutual funds might have distributed gains at the end of the year. Even if you don’t sell your shares, you might receive a distribution from the mutual fund and, even if it’s reinvested, you’ll be responsible for paying the gains.
While there is a chance of seeing similar distributions from ETFs, they are less commonplace, and redemptions from authorized participants usually take place on an in-kind basis.
Over the years, the differences in expense ratios between ETFs and index mutual funds have narrowed, although index ETFs are likely to have lower expense ratios.
Depending on the broker used, you might have transaction fees for various ETFs or index funds. However, there are brokers that don’t charge transaction fees for certain ETFs or index funds. For example, Fidelity doesn’t charge transaction fees on some of its index mutual funds and you won’t pay transaction fees on ETFs.
Many of the newer online discount brokers don’t offer mutual funds. Instead, you can choose to invest in ETFs and index ETFs. For example, Stash offers index ETFs in addition to regular ETFs, but you can’t access index funds. Many robo-advisors, like Acorns, use ETFs to construct their portfolios, so the only fees you pay are the expense ratios and the monthly fee, which can be a percentage of assets managed or a flat monthly fee. You can learn more by reading our Acorns vs. Stash comparison.
However, it’s important to be aware of potential fees, like sales loads that might come with mutual funds. These fees can be added at the beginning when you make your purchase or when you sell later. Additionally, some mutual funds have redemption fees if you sell shares within a set period of time.
Be aware of how commissions, account fees, sales loads, and other costs might impact your purchase. In general, ETFs are often considered to have lower fees. However, some low-cost index mutual funds, such as those offered by Vanguard, have low expense ratios and don’t come with extra fees.
Should you invest in an ETF or index fund?
Whether you should invest in an ETF versus an index fund depends on your goals and strategies; what you’re trying to accomplish; and what’s available through the broker of your choice.
If you want to be able to place market orders and buy and sell a pooled investment with ease, an ETF can be a good addition to your portfolio. Additionally, if you’re interested in using robo-advisors to handle your portfolio management, ETFs might be the smart fit. On top of that, ETFs can do well for those who want exposure outside of the overall stock market. For investors looking for exposure to currencies, commodities, or growth stocks, ETFs can offer easier access.
On the other hand, if you’re more interested in growing your wealth based on the overall market’s performance, an index mutual fund can be a good choice. Index mutual funds work well for those looking to buy and hold and can be good choices for retirement accounts. This can be especially true for tax-advantaged retirement accounts. If you hold mutual funds in tax-advantaged accounts like IRAs and 401(k)s, you don’t have to worry as much about the tax consequences related to what’s going on inside the mutual fund each year.
Don’t forget that it’s possible to invest in both ETFs and index funds. You don’t have to choose between an active versus passive investing strategy. You can include elements of both. You can use both in your portfolio to help you meet different goals. Consider your investment strategy to decide where your money should go and how to divide your portfolio between different types of investments.
Is it better to invest in an ETF or mutual fund?
ETFs and mutual funds are both pooled investments with their own advantages and disadvantages. With a mutual fund, you own shares of the included investments. With an ETF, you have exposure to the assets, but you don’t actually own shares of the underlying assets. On the other hand, ETFs are easier to buy and sell than mutual fund shares.
What is the downside of ETFs?
For some investors, the idea that they don’t own the underlying assets and that an ETF is a derivative can be a downside. Additionally, depending on the type of ETF you get, there can be a chance that the value of the underlying assets is different from what’s reflected in the share price of the ETF.
What is the average return on ETFs?
Each ETF is going to have its own average rate of return. For example, an index ETF that tracks the S&P 500 will have a rate of return similar to the S&P 500. This historically averages out to close to 10% per year.
However, just like any stock or other investment, some returns are higher. For example, there are technology and other ETFs in specific industries with five-year returns exceeding 200%.
In the end, however, past performance is no guarantee of future results and you might not see these types of returns on ETFs in the future. Carefully do your research before making any investment decision.
When deciding between an ETF and an index fund, carefully consider what you’re trying to accomplish and the characteristics of each type of investment.
ETFs can be convenient if you want access to instant diversity and exposure to various asset classes, and you want to trade on an exchange. An index fund can be a good choice for the portion of your portfolio designed for long-term buy and hold.
Consider consulting with a financial advisor as you move forward to determine how best to construct a portfolio using ETFs and index funds.
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