ETF vs. Index Fund: What You Need To Know

etf vs. index fund

There is no better time to be a passive investor. Thanks largely in part to the explosive growth of exchange traded funds over the years. The first U.S. ETF was created in 1993 and we haven’t looked back since. Before that, passive investors primary option was index funds. Today, they have both options.  But what is best for you, ETF vs. Index Fund is a discussion worth having.

ETF vs. Index Fund

Source: Vanguard

Now, an index fund is a type of mutual fund that tracks the components of a market index. For example, there are index funds that track the S&P 500 index. That said, there are ETFs and ETNs that also track the S&P 500.

Let’s take a look at some of the similarities and differences between Index Funds and ETFs.

ETF vs. Index Fund: Similarities

Rules Based Approach

Since an index fund tracks an index, fund managers are trying to replicate the performance of the index. They are not “stock picking” in hopes of beating of beating the market, instead they are following specific rules in order to replicate the tracking index. That said, the expense ratio of index mutual funds are generally far less than a mutual fund that has an active manager.

The same can be said about ETFs that track an index. These funds are not actively managed, instead they are following specific guidelines in order to track the benchmark index.

They Both Offer Similar Products

For example, some index funds that track the S&P 500 include: Schwab S&P 500 Index Fund (SWPPX); T. Rowe Price Equity Index 500 Fund (PREIX); and Fidelity Spartan 500 Index Investor Shares (FUSEX).

That said, ETFs that track the S&P 500 include:  SPDR S&P 500 ETF (NYSE: SPY); iShares Core S&P 500 ETF (NYSE: IVV); and Vanguard S&P 500 ETF (NYSE: VOO).

Furthermore, ETFs and index funds are both considered pool investment vehicles that are highly transparent.

ETF vs. Index Fund: Differences

ETFs Are More Accessible & Liquid

ETFs are traded on the stock market. All you need is an online brokerage account to get started. You can buy and sell them the same way you do a stock. On the other hand, index funds must be bought directly through a broker or the actual fund itself.

In addition, ETFs can be bought and sold throughout the day, including pre- and post market hours.  Generally, index fund transactions are cleared after the market closes.

For example, if you’re long the T. Rowe Price Equity Index 500 Fund and want to bail out at 10 AM because you feel the market is going to sell off, the transaction won’t be cleared until the end of the day, potentially leading to bigger losses.

ETFs are better for more active traders than index funds.

Some Index Funds Require A Minimum Investment

Some fund managers require a minimum investment that is too high for small investors, making the barrier of entry harder for them. For example, the minimum investment for Vanguard 500 Index Fund Investor Shares (VFINX) is $3K.

On the other hand, you can buy one share of an ETF if you so desired. The barrier of entry is lower for ETFs compared to most index funds.

Fees & Expenses

ETFs generally have a lower expense ratio.

SPDR S&P 500 ETF (NYSE: SPY):

spy etf vs. index fund

Source: State Street Global Advisors

Vanguard 500 Index Fund Investor Shares (VFINX):

VFINX etf vs. index fund

Source: Vanguard

In addition, some index funds may require investors to pay a sales load. A sales load is an upfront fee that is typically paid to the broker who introduced the investor to the index fund.

etf vs. index fund

ETF vs. Index Fund: Other Nuances

Automatic Investing Flexibility

It’s true, ETFs are superior in terms of trading flexibility. However, index funds typically reinvest dividends, whereas an ETF won’t. An investor saves money because they don’t have to pay broker commissions to reinvest their dividends if they chose an index fund.

Tax Implications

Please note that nothing in this section should be considered tax advice. Always consult with a financial professional on the differences between investing in an ETF vs. an index fund.

That said, it’s possible that ETFs are more tax-efficient than index funds. The reason for that is in-kind redemptions.  Through this process, the ETF avoids selling securities to meet investor redemptions, which could in turn have favorable tax implications.

Again, speak with an accountant and other financial professional for a deeper discussion on the tax implications of index funds and ETFs.

Bottom Line

Index funds and ETFs are very similar. However, if you’re an active trader in the market than investing in ETFs is the way to go. On the other hand, if you’re a long term investor than it might not make a huge difference. But, the auto investing feature of index funds might be enough of a selling point if you’re a buy and hold investor.

ETFs offer a lower barrier of entry for those looking to get involved in the markets and have a small trading account. In addition, expense ratio’s are typically lower for ETFs when compared to index funds.

As always, do your own due diligence to see whats best for your specific situation and financial goals.

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