Index Funds vs. ETFs: What's the Difference?
For new investors, index funds and Exchange-Traded Funds (ETFs) are two of the best ways to start building a diversified, low-cost portfolio. They are very similar but have a few key differences in how they trade. Excellent overviews are available from the U.S. Securities and Exchange Commission (SEC).
What They Have in Common
- Passive Investing: Most ETFs and all index funds are designed to passively track a market index, like the S&P 500. They simply hold the stocks in that index, rather than trying to beat the market.
- Diversification: They offer instant diversification, spreading your investment across hundreds or thousands of companies.
- Low Cost: Because they are passively managed, they have very low expense ratios compared to actively managed funds.
The Key Difference: How They Trade
- Index Funds (as Mutual Funds): You buy and sell shares directly from the fund company (like Vanguard or Fidelity). All transactions are priced once per day after the market closes, at a price called the Net Asset Value (NAV).
- Exchange-Traded Funds (ETFs): ETFs trade on a stock exchange, just like an individual stock. You can buy and sell them throughout the trading day at a price that fluctuates based on market supply and demand.
Comparison Table for Beginners
| Feature | Index Mutual Fund | Exchange-Traded Fund (ETF) |
|---|---|---|
| Trading | Once per day, after market close | Throughout the day, like a stock |
| Minimum Investment | Can have higher minimums (e.g., $1,000+) | Can buy a single share (often < $100) |
| Automatic Investing | Excellent for setting up automatic, recurring investments of a specific dollar amount. | Possible, but can be less seamless than with mutual funds depending on the broker. |
| Tax Efficiency | Generally tax-efficient, but can have capital gains distributions. | Often slightly more tax-efficient in taxable accounts due to their structure. |
Which One Should a Beginner Choose?
The choice often comes down to personal preference:
- Choose an Index Mutual Fund if: You want to "set it and forget it" with automatic, recurring investments of a fixed dollar amount each month. The single daily trading price simplifies the process.
- Choose an ETF if: You want more trading flexibility, the ability to buy and sell during the day, or have a smaller amount of money to start with (since you can buy just one share).
Conclusion: Don't Sweat the Small Stuff
For a new, long-term investor, the difference between an index fund and a comparable ETF is minor. The most important decision is to start investing. Both are excellent, low-cost tools for building long-term wealth.
Disclaimer: Investment decisions should be based on individual financial goals and risk tolerance. Consult with a financial advisor if necessary.