ETF vs. Index Fund: Compared
ETFs and index funds are both great options for investing. So which one is right for you?
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What’s the best way to generate income while you sleep? 😴
For most investors, this is either ETFs or index funds. Both asset classes have their pros and cons, and the one you ultimately end up investing in will depend on a wide range of factors as well as your investment style.
But if you are new to the world of investing, both ETFs and index funds are a great way to start. This is because they are generally more stress-free than other forms of investing and are much easier for beginners to figure out. They also typically offer a low barrier for entry, meaning you don’t need a whole lot of capital to get started.
In fact, investing in both ETFs and index funds is so easy that investment legend Charles Ellis swears by the practice. This is because sometimes investing with fewer choices is overall an easier way to go, as you will be faced with less stress and be able to focus your investing strategy better.
But how do you choose between the two? Keep reading to learn all about ETFs, index funds, and ultimately, which is better for your portfolio.
- Understanding ETFs
- Understanding Index Funds
- ETFs vs. Index Funds
- The Advantages of ETFs Over Index Funds
- The Strengths of Index Funds Over ETFs
- Conclusion
- FAQs
- Get Started with a Stock Broker
Understanding ETFs 🧠
ETF stands for Exchange-Traded Fund, and it is used to discuss a type of stock market security that is based on an index or collection of other stocks or commodities. For example, a technology information ETF would be structured to split your investment into several different information technology companies like Tesla, Apple, and Microsoft.
But ETFs don’t just have to track a certain industry, as they can also be built to track an investment style or the stock market as a whole. You will see ETFs for this purpose, such as SDPR S&P 500, which, as the name indicates, tracks the prices of the S&P 500. There are also ETFs that track the prices of bonds and various currencies around the world.
ETFs are an extremely popular method of investing. This is because they tend to lower the risk of the investor by helping them diversify across multiple companies with an investment in one single fund.
Take the above example, and pretend you purchased an Information Technology ETF. Since it contains a collection of information technology companies, if one company goes under, say, Tesla, you won’t lose all your money. You may still experience a small loss, but not near as large of one if you had invested in Tesla alone.
ETFs overall lower the exposure of the investor to the market. Not only that, but they typically have low fees, making them a great place for someone new to stock investing to start, and they are easy to cash out of at any time. Additionally, you can trade ETFs all day long while the market is open, rather than being restricted to just a few trading hours at the end of the day.
The History of ETFs 📜
ETFs are a newer type of investment strategy, as they have only been around since the practice of indexing began in the late 1980s. The first ETF was created and released in 1993, and it was built to track the S&P 500.
The popularity of ETFs quickly took off from there, as investors realized what a good option they are for investing. By 1996, there were international ETFs that allowed investors a lower level of risk when being exposed to foreign markets.
Commodity ETFs joined the party in 2004, allowing investors more specific industry investments with the same low-risk approach guaranteed in an ETF. The expansion continued from there, making ETFs the $4.04 trillion dollar industry they are as of 2019.
Understanding Index Funds 💡
Index funds, while being a type of ETF, are subject to their own rules and regulations. Index funds specifically follow an index of a specific market, such as the S&P 500. And in this case, this means that when you buy one share of an index fund, you are actually buying small shares in all of the companies included in the S&P 500.
This gives investors exposure to multiple companies on the market while keeping their overall risk lower than if they were to invest in individual companies. Many people with a retirement fund are encouraged to invest in index funds because of their low risk and high diversity.
Index funds maintain low fees, as they don’t require the expensive stock analysts as other investment products need. This is known as passive fund management, and it typically keeps the fees at an amount that is below 1% per year.
The History of Index Funds 📜
Index funds, since they are an ETF, follow the same history listed above. The only difference is, index funds can specifically trace their origin back to two individuals, Edward Renshaw and Paul Feldstein, who first broached the idea of an unmanaged investment fund all the way back in the year 1960.
Of course, this was but a small idea in a time of big innovation, and the idea fell to the wayside until John Bogle started the first index fund in 1975, the Vanguard 500 index fund. And although it received opposition at first, within 5 years, it had netted over 17 billion dollars.
Since then, index funds have grown to include other types of markets, from small to large, as well as some that focus on bonds versus those that focus on dividends. You can also invest in more risky types of index funds, such as those that include leveraged investments.
How Are ETFs and Index Funds Different, Exactly? 🤔
By now, you’ve probably noticed that ETFs and index funds sound like very similar ways to invest your money. But they are truly different investment products, and it’s critical that you know the differences so that you are able to select the one that is better for your investment style.
| Features | ETFs | Index Funds |
|---|---|---|
| Diversified Holdings | Yes | Yes |
| Traded on Exchange | Yes | No |
| Intraday Trading | Yes | No |
| Expense Ratios | Usually Lower | Usually Higher |
| Dividend Payments | Usually Distributed to Investors | May be Automatically Reinvested |
| Management | Generally Passive | Generally Active |
| Fees | 0.44% on Average | 0.74% on Average |
| Minimum Investment Requirements | Usually Lower | Usually Higher |
Trading Fees 💵
As mentioned above, both ETFs and index funds tend to have low expense ratios. But like anything else in the investment world, you should know by now that there is more than one type of fees involved in trading both ETFs and index funds.
In general, ETFs are not subject to additional trading fees above the expense ratios. And if they are, they are very low. Meanwhile, you can expect there to be additional fees for trading index funds, unless you’re using one of the top brokers for free trades.
And even if you manage to find a fund that doesn’t have additional fees for trading index funds, you should know that these funds are also subject to load fees. Load fees are a type of sales commission, and they can be charged for both buying and selling funds.
ETFs almost never have load fees, but they are subject to another type of fee known as the bid-ask spread that index funds don’t have. This fee is usually negligible if you are buying large volume ETFs. But when buying smaller ETFs, beware that this fee may be tacked on to the trade.
This means that although both index funds and ETFs may appear to have low expense ratios, you need to dive in deeper before purchasing index funds as they may be subject to many hidden fees.
Taxes 🧾
Something big you need to worry about when you get involved in the world of investing is taxed—and how much you will owe when you eventually decide to sell your investment. When holding ETFs, you are generally not subject to any taxes. Rather, you will pay capital gains taxes when you decide to eventually sell your position. This is convenient because you will not owe taxes as the fund managers change various positions in the ETF.
Index funds, on the other hand, are typically tracked as the index is changed. While this may sound a bit scary, know that holdings in an index fund don’t often change. But you need to be aware of this fact before you invest.
Not to mention that the capital gains taxes can be shared with all investors within an index fund. This means that you could end up paying capital gains taxes even if you didn’t buy or sell anything out of your index fund that year. This factor alone can make index funds quite shocking for new investors.
Minimum Investment Amounts 🪙
Many investors gravitate towards index funds and ETFs because they believe they require a low initial investment to get started. While this is generally true, investors should be aware that sometimes index funds have minimum initial investments. And these minimum investments can be in the thousands of dollars. ETFs never have a minimum investment amount.
Fractional Shares 📊
You may already be rethinking index funds because you have found out they have minimum investment amounts. But before you brush them off, you should know they have one thing on ETFs, and that is that you can buy fractional shares.
Generally, you cannot purchase fractional ETFs, though a few different brokerages now offer this ability. While it may not seem like a big deal, purchasing fractional shares can help you to make more money sooner and can help you to actually take home more money over time.
When They Are Bought or Sold 💸
Something you may not realize about index funds and ETFs is that there is a difference in when they are bought and sold. ETFs can typically be traded throughout the day, and their price will fluctuate with every buy and sell. Meanwhile, index funds are only available for purchase at their end-of-the-day price.
This means almost nothing if you are planning to buy your stocks and hold them for a long time. But if you are looking to day trade, this generally means that you should avoid index funds since they will only be tradable at the end of the day.
Average Yearly Returns 💰
But of course, the most important question you are asking is which will make you more money. This will honestly depend on the broker you decide to invest through. But to give you an idea, take a look at a comparison of the yearly return of some of the following common funds.
Vanguard is a very popular brokerage among passive investors, and they do offer both ETFs and index funds. In 2020, their index fund SPX which differs from SPY as the former tracks the S&P 500, returned a total of 14.80% of investments over the course of the year, while their famous large-cap company ETF called VV had a return rate of 17.10% for the same time period. So clearly, in this situation, the person who invested in the ETF came out ahead.
Let’s compare two more funds that track a very similar set of stocks. OEF is a popular ETF that tracks the top 100 U.S. companies, and it grew by 19% in 2020. On the other hand we have the US100, which is an index fund—it grew around 46% during the same year.
These examples indicate that even an ETF and an index fund that track the same markets can have vastly different returns. Much of this will depend on the funds’ management and their expense ratios, so make sure to look at all your investment options when you decide which sector of the industry you want to invest in.
💡 Interested in a human-robo advisor hybrid? Learn about the pros and cons of Vanguard’s PAS.
Risk ⚠️
Both index funds and ETFs are generally low-risk investments. This is because your money is split across several companies rather than banking on one. But even so, the risk differs slightly between the two forms of investing.
This is because index funds split your money among several different companies, while ETFs tend to focus on one certain type of company. This doesn’t mean you can’t find broad ETFs; it just means they tend to be less broad than index funds.
This can be helpful for someone who always believes the stock market is about to head for a bear market because they can sleep easy knowing their investments are diversified. But this also makes it difficult if you believe there is money to be made within a certain industry like technology.
Accessibility 🚪
One big difference between index funds and ETFs is their accessibility to the average investor. While index funds are typically available in 401k and other group investment plans, ETFs are not. If you invest in an IRA, on the other hand, ETFs are typically available.
But, if you have a 401k, don’t despair, as you can still have access to investing in ETFs via a taxable account with an online brokerage company. These companies can occasionally require a base investment amount. You’ll want to do your own research to be sure you find the leading online brokerage to trade ETFs.
And there are some companies that allow investments in both index funds and ETFs if you want to explore both options. These companies, however, will likely require a minimum deposit and that you create an account to use their services. And if someone cannot qualify for one of these accounts, it can make it difficult for them to trade products not provided by their employer (typically ETFs).
Still confused? Take a look at the chart below to give you an idea of which of the two might be better for you.
| Aspect | ETFs | Index Funds |
|---|---|---|
| Fees | Low, but there could be some hidden ones. | Low, but could be some hidden ones. |
| Taxes | Paid only at the end | Paid while holding |
| Minimum Investment | Enough for 1 share of an ETF | Varied based on broker |
| Fractional Shares | No | Yes |
| When They Can Be Traded | Anytime | End of the trading day only |
| Risk | Low | Low |
| Accessibility | Usually requires a personal, taxable account with a broker. | 0.74% on Average |
| Order Types | A large variety depending on the site. | Only market orders available |
The Advantages of ETFs Over Index Funds 📈
Still not convinced that ETFs are the way to go? Well, it’s time to look at some outright advantages to investing in ETFs.
First and foremost, the most obvious advantage to ETFs is that they tend to have a lower cost than index funds. Although the fee structure can be confusing, ETFs tend to have a lower yearly cost as well as less fees than their index counterparts. And, if you register with a reputable online stock trading app, you will often find that you can trade their ETFs completely fee-free.
When you are first starting out as an investor, the last thing you want to worry about is the taxes you will have to pay when you cash out. And with ETFs, you truly will only have to worry about taxes when you cash out, while other types of funds have fees that could come back to haunt you at any time in your investing career. This is why ETFs are considered superior in the investment space.
ETFs are also a better way to focus your funds while also diversifying them. For example, with ETFs, you can focus your money in the tech industry without having to invest in one single tech company. Instead, your money is spread over 100 different tech companies while still keeping your money within the industry. This is much different than index funds, where you don’t have as much say in the industries to which your money goes.
The Strengths of Index Funds Over ETFs 💪
Ready to go out and buy ETFs? Well, before you do, you should know some of the outright strengths that index funds have over ETFs.
One of the main aspects of ETFs that is an advantage is also its weakness. When it comes to index funds, your money is split between some of the highest-performing companies in the stock market. And these companies are often completely different and in several different industries.
This type of diversification is important because if you put all your money into a Bitcoin ETF, and then the government makes it illegal, even though your money is spread between several different companies, the whole industry is facing potential regulation. With index funds, you might notice a slight dip in the same example, but it won’t be all-out decimation.
For this same reason, this means that an investment in index funds is much more likely to bounce back from a market downturn than a specific ETF investment.
Plus, when you put your money into an index fund, it is generally stress-free. Because you won’t be withdrawing and placing new investments regularly, investing in index funds protects you from some of the common errors made from trading psychology. This means you won’t panic sell because you are planning to hold your index funds for the long term.
Conclusion 🏁
So, in the end, whether or not you decide to invest your money in ETFs or in index funds widely depends on your investment style and what you intend to do over the long term. If you want to leave your funds in a low-risk environment for years to come, then an index fund is the way to go. But if you think you will like day trading and looking for money in certain industries, then it’s best to stick with ETFs.
Either way, putting your money into ETFs and index funds are both wise decisions. These are some of the lowest risk, lowest barrier entry methods to invest–and everyone has to start somewhere! Just remember to take a look at all the fees of a platform before you begin, as well as research the industries you plan to invest in. Otherwise, there’s no reason to wait and get started with your investing right away!
ETF vs. Index Funds: FAQs
-
How to Invest in S&P 500 Index Fund?
You can invest in an S&P index fund by signing up for an account with a broker that sells these specific funds. Sometimes you can also invest in this fund through your 401k account facilitated by your employer.
-
What is a Low-Cost Index Fund?
A low-cost index fund is any index fund with an expense ratio of below 0.5%, though you can often see expense ratios as low as 0.1% if you pick the right funds.
-
How Does an ETF Make Money?
ETFs make money through the expense ratios that they charge the buyers of the fund. These are yearly fees that cost the investor a percentage of their holdings—usually from 0.1% to 0.5%.
-
Is S&P 500 an ETF or Index Fund?
The S&P 500 is both an index fund as well as an ETF. Specifically, Standard & Poor’s 500 refers to the 500 largest companies on the U.S. stock market. Any fund can invest in these.
-
Do ETFs Pay Dividends?
An ETF will pay dividends if any of the stocks contained in that ETF pays dividends. This means if you have an ETF of dividend stocks, you can expect to receive dividends.
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