ETFs vs. index funds: Which one is better for you?

For some investors, distinguishing between exchange-traded funds (ETFs) and index funds is confusing. The trick is to think of index funds as a broad category that encompasses both mutual funds and ETFs that track market indexes such as the Dow Jones Industrial Average or S&P 500.

Where it can get confusing is that some index funds are ETFs, but not all are. In fact, some are structured as mutual funds. Likewise, some ETFs are index funds, but not all are. Differentiating between these differences as you decide on the right investments for your needs is important.

But what exactly is an ETF? An ETF is a type of fund that trades on stock exchanges like individual stocks, and is comprised of a basket of assets typically tracking an index, sector, commodity or other asset type.

You may decide that non-index ETFs and index funds broadly speaking may have a place in your investment portfolio. These funds are diversified, relatively easy to handle and designed to save you (the investor) time and energy.

While non-index ETFs and index funds are both “hands off” investments that require minimal maintenance, you’ll want to choose funds based on your long- and short-term investment goals.

We’ll break down what ETFs and index funds are, so you have a clear idea of which would work best to suit your needs.

What is an ETF?

An ETF is an investment vehicle that’s composed of a basket of assets, such as stocks, bonds, commodities and currencies, and can be traded on a market exchange. They can be tailored to provide exposure to certain market segments like a sector or asset class.

ETFs are also sometimes constructed to track the performance of a market segment or index. In simpler terms, ETFs may be considered index funds, but they may not be, depending on the ETF and its assets.

Not all ETFs are designed to track an index. Non-index ETFs might focus on specific sectors like financials or consumer discretionary, or themes like artificial intelligence or clean energy, or use complex trading strategies involving options and leverage, to build and maintain a portfolio of assets.

How do ETFs work?

An ETF pools several different underlying assets into a single entity, which may be more appealing to an investor seeking instant diversification.

These assets could be stocks from various industries or sectors or may include bonds, commodities and other tradable financial instruments.

The main benefit of ETFs over other funds, like mutual funds, is they can be traded like stocks. Trades are transacted almost immediately after they are submitted for execution.

Plus, the fact that they are often passively managed means they often have low operating costs, which can potentially result in higher returns for the investor. They are highly liquid and can also offer tax advantages in some cases.

Additionally, an ETF may pay dividends if an individual security within the fund pays dividends.

What is an index fund?

An index fund is a type of mutual fund or ETF that tracks a benchmark index. Investing in an index fund results in buying into all the securities that comprise that index.

For example, buying an index fund that tracks the S&P 500 means the investor has bought a piece of the 500 largest companies listed on the New York Stock Exchange (NYSE), Nasdaq and the Chicago Board Options Exchange (CBOE).

This can help them diversify their portfolio, as the companies in the S&P 500 are thought to offer exposure to a broad cross section of the U.S. economy.

How do index funds work?

An index fund pools its investor’s money to invest in the assets to track a benchmark index. Its investment style is described as being passive in that the goal is to track the returns of that benchmark index.

This approach eliminates the need for active stock picking and market timing, making it a more hands-off and cost-effective investment option. By investing in an index fund, investors gain exposure to a broad market segment and can benefit from the overall performance of the index over time.

What are low-cost index funds?

A low-cost index fund has lower fees associated with owning it. One of the “secrets” to investing is the power of compounding.

Management fees are subtracted from the invested amount periodically (usually annually). This means there’s less capital to be reinvested, which may result in a lower return for the investor over time.

What is an ETF vs. an index fund: A comparison

What are the similarities between ETFs and index funds?

ETFs and index funds share many similarities, and in some cases a specific ETF is also an index fund: Let’s do a deeper dive.

Diversification

Both non-index ETFs and index funds offer diversification.

When you invest in an ETF or any index fund, you’re not placing your money on one single company or asset. Instead, the funds pool a variety of assets into a single portfolio, spreading risk across multiple securities, such as stocks, bonds or commodities.

That way, if one specific stock or bond underperforms, the other investments in the fund may help balance the overall return. This broad exposure to various sectors or asset classes may help reduce the risk of relying too heavily on one entity, creating opportunities for steadier growth over time.

Whether your goal is building long-term wealth for your family or creating a retirement fund, diversification through ETFs and all types of index funds may help make your investments more resilient to market fluctuations, especially compared to individual stock picking.

Market exposure

Non-index ETFs provide investors with the ability to target their market exposure.

Whether an investor is interested in technology stocks, sustainable energy investments or international markets, there are non-index ETFs tailored toward specific areas of the economy.

Index funds, meanwhile, whether they are mutual funds or ETFs, provide broad market exposure because they track a specific market index, such as the S&P 500, the Nasdaq or the Russell 2000.

Do ETFs or index funds offer better returns?

When it comes to the potential returns of non-index ETFs and index funds, it's important to note that both investment options are tied to the performance of the underlying assets they represent.

A key difference is that, generally, ETFs tend to have lower expense ratios compared to index funds that are structured as mutual funds. This can be attributed to the structure and operational differences between the two investment vehicles.

Lower expense ratios can potentially have a positive impact on net returns over the long term since you pay less money to maintain your investment gains.

That said, there are also reasons investors may want to invest in mutual funds, one being that there are options that are actively managed.

Which is safer investment: An ETF or index fund?

Both non-index ETFs and index funds offer investors a diversified portfolio, which helps to mitigate the impact of the poor performance of any single company or security on the overall investment.

That said, the potential for risk in both non-index ETFs and index funds can still be influenced by various factors, including the underlying assets, market conditions and fund management. While both investment options aim to minimize risk through diversification, you still need to carefully evaluate the specific assets and markets the funds track.

Also, you should consider factors such as expense ratios, liquidity and the reputation and track record of the fund when you’re deciding which option is safer.

Are ETFs better than index funds?

In the “ETFs vs. index funds” debate, it’s clear that both options can potentially benefit investors.

Both non-index ETFs and index funds offer diversification, relatively passive management and a way to decide the kind of market exposure you want your investment to have, be it targeted or broad.

However, there are differences between them that may make one better suited to your objectives and investment style than the other.

ETFs vs. index funds: How to choose

Choosing between ETFs and index mutual funds is generally informed by your individual financial goals and personal investing style.

While both offer unique advantages, your preference could hinge on specific personal and financial considerations. Here are some questions that might help guide your decision:

Do I need the flexibility to buy and sell throughout the trading day, or am I comfortable with end-of-day trading?

Before considering an ETF or index mutual fund, you’ll want to see if they allow you to make investment decisions throughout the day or if they’re limited to trading at end-of-day only.

Understanding this could be especially beneficial if you’re aiming to capitalize on short-term market fluctuations or if you prefer having more control over the timing of your trades. Those with longer time horizons may be more comfortable with the more set-and-forget, end-of-day trading style of index mutual funds.

Would a lower minimum investment be helpful for my financial situation?

Consider your financial circumstances and the minimum investment required for each option. Again, ETFs generally have lower minimum investment requirements, making them more accessible for investors with limited capital.

Index mutual funds, on the other hand, may require higher minimum investments.

How do I prioritize tax efficiency in my investment portfolio?

ETFs are structured in a way that allows for greater tax efficiency due to their unique creation and redemption mechanism.

This can result in potential tax advantages, especially in taxable accounts. Index mutual funds may not offer the same level of tax advantages as ETFs.

Starting the process: How to buy index funds and non-index ETFs

Getting started with either index funds or non-index ETFs is a relatively straightforward process. Here’s what to do:

1. Research and educate yourself

Before investing, dedicate some time to learning the basics of index funds and non-index ETFs. Familiarize yourself with the different fund options, their objectives and associated costs. Compare the various funds, and assess their historical performance.

Remember, investing involves risk, and it's a good idea to consult with a financial advisor who can provide personalized advice tailored to your specific financial situation and goals.

2. Set investment goals

Determine your investment goals and risk tolerance. Consider your time horizon, financial objectives and how much risk you’re willing to take on. This will help you choose the most suitable index funds or non-index ETFs for your portfolio.

3. Choose a brokerage account

To buy index funds and non-index ETFs, you'll need to open a brokerage account. Research reputable online brokerage firms that offer a wide selection of funds, reasonable fees and user-friendly platforms.

Consider factors like account fees, investment options, customer service and educational resources when selecting a brokerage account.

4. Fund your account

Once you've chosen a brokerage account, you'll need to fund your account. This typically involves linking your bank account to your brokerage account and transferring funds electronically. Be mindful of any minimum investment requirements that may apply.

5. Select the funds you want to invest in

Using the research you've done, select the specific index funds or non-index ETFs that align with your investment goals. You may want to look for funds that have a record of strong performance, low expense ratios and match your desired exposure to different asset classes or sectors.

6. Place your order

Once you've identified the funds you wish to invest in, place your order through your brokerage account. Specify the number of shares or dollar amount you want to invest.

Keep in mind that market orders are executed at the prevailing market price, while limit orders allow you to set a specific price at which you’re willing to buy.

7. Monitor and review your investments

After purchasing index funds or non-index ETFs, it's important to regularly monitor your investments. Keep an eye on market trends, fund performance and any changes to the underlying investment.

Review your portfolio periodically to make sure it remains aligned with your investment goals, and make any necessary adjustments as needed.

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