ETFs vs. index funds: What you need to know

When it comes to investing, two popular options for potentially diversifying your portfolio without a lot of hassle and high fees are exchange-traded funds (ETFs) and index funds. Understanding the basics of these investment vehicles can help you make more informed choices about which vehicle—or even a mix of both—might be right for you.

Let’s break down some similarities and differences between ETFs and index funds.

Passive ETFs and index funds are cousins

Passive investing strategies are typically designed to track the performance of market indexes. Actively managed funds, on the other hand, have managers picking securities with a goal of outperforming benchmarks or other specific outcomes.

To be clear, both ETFs and mutual funds can be passively or actively managed. However, passive ETFs and index funds can be considered cousins because they typically have the same goal (replicate the performance of an index), although their structures are somewhat different, as we’ll discuss later.

Here are some other key similarities between ETFs and index funds:

• Diversification made easy: Both ETFs and index funds provide a simple and convenient way to gain exposure to a broad range of securities, such as stocks and bonds, without needing to buy each one individually yourself. Both structures also give individuals access to professional investment management.
• Lower fees: Since both ETFs and index funds are typically designed to track a benchmark, that can make them more cost-effective compared to actively managed funds, which often charge higher fees due to the research and expertise required for stock picking.¹ In 2023, index equity mutual funds and passive equity ETFs had asset-weighted average expense ratios of under 0.20%, compared with 0.65% for actively managed equity mutual funds.¹
• Wide range of asset classes: Whether you’re interested in domestic or international equities, corporate bonds, commodities, real estate, or other asset classes, both ETFs and index funds let you invest across a broad spectrum. This flexibility helps investors tailor their portfolios to their specific financial goals and risk tolerance.

How they’re different

While ETFs and index funds share several similarities, they also have some important differences to keep in mind:

• Trading flexibility:
  • Index funds: These are priced only once each day at the market close. This means whether you place an order to buy shares in the morning or late in the afternoon, you'll pay the same daily price.
  • ETFs: Unlike mutual funds, ETFs are traded on an exchange like stocks, which means you can buy and sell them throughout the trading day. This flexibility allows investors to take advantage of intraday market movements, which can be especially beneficial during periods of market volatility.
• Tax efficiency:
  • ETFs are generally more tax-efficient than mutual funds. This efficiency comes from the unique "in-kind" creation and redemption process of ETFs, which minimizes taxable events. As a result, ETFs tend to distribute fewer capital gains to shareholders compared to mutual funds. This can be attractive to investors looking to minimize their tax liabilities in a taxable account.
• Minimum initial investments:
  • Index funds: The minimum initial investments for index funds can vary, but they often range from $1,000 to $3,000.²
  • ETFs: Many brokers allow you to buy as little as a single share of an ETF, making them accessible even to investors with limited capital.
• ETF considerations:
  • While index-based ETFs typically have low expense ratios, it's worth noting that they do have trading costs, such as bid/ask spreads, similar to individual stocks. However, for highly liquid ETFs like Invesco QQQ, these spreads are typically small. For niche ETFs that aren’t heavily traded, however, the bid/ask spread can be quite large. Investors should consider both the expense ratios and the trading costs when choosing between an ETF and an index fund. Many brokers today allow commission-free ETF trades, but it’s always a good idea to check.

Selecting the right vehicle for your needs

Both ETFs and index funds have key similarities and differences that can influence which option is best for you. Whether you prioritize trading flexibility, tax efficiency, or ease of access, understanding these factors can help you choose the vehicle that aligns with your investment goals and preferences. We hope this short primer provides you with a clearer understanding of ETFs and index funds and helps you make an informed decision about which one—or a combination of both—could be right for you.