ETFs vs. index fund: what's the difference? (2023)

An ETF is exactly what its name suggests: an exchange-traded fund. ETFs are some of the most actively traded securities on US exchanges, with hundreds of millions of shares changing hands during each trading session. Popular ETFs include SPY (SPDR S&P 500 ETF Trust), VOO (Vanguard S&P 500 ETF), QQQ (PowerShares QQQ ETF), and GLD (SPDR Gold Shares ETF).

Like mutual funds, ETFs invest in a basket of securities such as stocks, bonds and commodities. However, unlike mutual funds, ETFs trade like stocks when the markets are open, experiencing price fluctuations throughout the day. While ETFs can be passively or actively managed by fund managers, most are passive investments.

ADVICE:Mutual funds and ETFs are not guaranteedor the insuredFDICor any other government agency, even if you buy the shares through a bank and the fund is named after the bank.

An index fund is an investment fund (mutual fund or ETF) that mimics the investment return of a specific market index. Like most ETFs, index funds are passively managed. This means that the investment mix is ​​automated to match the stocks in the underlying index - rather than hand-picked by the fund manager.

While the most popular index funds follow the S&P 500, other widely followed indexes include the Dow Jones Industrial Average (DJIA), Nasdaq 100, Nasdaq Composite, NYSE Composite, Russell 2000, and Wilshire 5000.

ETFs and index funds are baskets of securities combined into one investment, but that's not the only similarity. They are attractive to investors for several common reasons.

1. Diversification

ETFs and index funds invest in all securities within a specific index, offering instant diversification assistancereduce risk and volatilityin your portfolio. For example, funds that track the DJIA provide exposure to 30 US blue chip stocks, while funds linked to the S&P 500 offer exposure to the 500 largest companies on the US stock market.

2. Low fees

Because index funds and most ETFs are passively managed, they tend to have much lower expense ratios than actively managed funds. According to the most recent expense ratio study by the Institute of Investment Firms, stock index funds charge an average expense ratio of 0.07%, while stock ETFs charge an average of 0.18% (though many are much lower). By comparison, actively managed equity mutual funds charge about 0.74% on average. The difference may seem small, but even slightly higher spend rates can significantly reduce ROI over time.

3. Strong long-term returns

History shows that passively managed index funds and ETFs consistently outperform actively managed mutual funds in the short (annual) and long term.The latest SPIVA S&P Global Scorecardshows that 93.40% of US large-cap funds have underperformed the S&P 500 over the past 15 years.

ETFs and index funds have a lot in common, but also some key differences.

1. How you buy them

The biggest difference between ETFs and index funds is the way they trade. ETFs trade like stocks on exchanges and you can buy, sell, buy and buy to cover them through your broker throughout the trading day. For index funds, you can submit orders through the fund manager at any time, but trades only take place once a day after the market closes. As a result, ETF prices fluctuate throughout the day, while index fund prices are updated only once.

2. Minimum investment

ETFs have no minimum purchase requirements, so you can invest as much as you want—even if it's just one stock. On the other hand, many index funds have minimum values ​​that can be up to thousands of dollars.

3. Transaction fees

Index funds and ETFs have significantly lower expense rates than actively managed funds, but other expenses can vary. For example, most brokers offer dozens or hundreds of commission-free ETFs, but commissions on index funds can be expensive (depending on the broker and the fund you want to buy). In addition, index funds often have top-up fees, another type of commission that is charged when you buy or sell a fund. ETFs do not have these fees.

4. Tax consequences

ETFs and index funds are tax efficient compared to actively managed funds, but ETFs have an advantage. You owe capital gains tax whether you sell shares in an index fund or ETF at a profit. However, when index funds buy and sell assets, capital gains are taken away from the fund, affecting the value of your shares. You will pay no tax when the ETF holdings are adjusted.

Passive investing through index funds and ETFs can be an attractive strategy, especially if you don't have the time, knowledge or interestresearch specific stocks, bonds and other investmentsinclude in your portfolio. Choosing one type of investment over another can come down to how each one trades. Still, whether you invest in an index fund or an ETF, you'll benefit from broad diversification, low expenses, and historically high long-term returns.

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This article was originally published onSFGate.comand reviewed by Lauren Williamson, who serves as the Financial and Home Services Editor on the Hearst E-Commerce team. Send her an e-mail at the addresslauren.williamson@hearst.com.