Index funds and exchange-traded funds are two popular types of investments for investors who prefer a passive approach. Index investing can offer a low-cost way to quickly invest in a variety of stocks, bonds, or other assets. And index ETFs can give investors easy access to these types of funds throughout the trading day.
What is an index fund?
An index fund is an investment vehicle that uses an index as a benchmark and tries to replicate the index’s returns. “Index” is the strategy and “fund” is the vehicle, and funds can come in different forms: They could be index mutual funds or index exchange-traded funds (ETFs). Index mutual funds pre-date index ETFs, but index ETFs are far more popular with investors today, thanks to their low cost and ease of trading.
One popular benchmark stock market index is the Standard & Poor’s 500 Index. The S&P 500 tracks stocks from 500 of the largest U.S. companies in different leading industries. The owner of the index uses proprietary criteria and weighting to decide which companies to include and how much weight to give each company’s stock. However, the index is only a tracker. If investors want to invest in line with the S&P 500, they have to buy an index fund that’s linked to the S&P 500. They could buy, for example, the SPY ETF or the VFIAX mutual fund. Both track the S&P 500.
What is an ETF?
An ETF pools investors’ money to invest in stocks, bonds, and other assets. ETFs are traded on stock exchanges, similar to individual companies’ stocks. However, by buying shares in an ETF, investors are investing in a fractional share of all the underlying assets.
Most ETFs are passively managed, meaning they simply attempt to track the performance of an index—these are index funds in the form of ETFs. A number of index ETFs track the S&P 500, while others try to mirror other indexes. Still others track the entire U.S. stock market, international markets, and non-stock assets, such as bonds or commodities.
Companies can also create index ETFs focused on specific industries, sectors, or values. For example, the Impact Shares NAACP Minority Empowerment ETF (NACP) tracks the Morningstar Minority Empowerment Index. In turn, the benchmark index tracks companies that have strong racial and ethnic diversity policies.
There are also actively managed ETFs and non-traditional passive index funds, such as smart beta ETFs, which use alternative factors to decide which investments to track. These funds aim to outperform their benchmarks. They aren’t as common as the traditional passive index ETFs.
Similarities between index mutual funds and ETFs
When an ETF tracks a market index, it is an index fund. But index funds can also be mutual funds. Index mutual funds and ETFs have the following similarities:
- Diversification. A broad index fund could include hundreds or thousands of stocks or bonds.
- Low cost. Passive index funds—both mutual funds and ETFs—tend to have low management fees—called expense ratios.
- Availability. ETFs and index mutual funds are widely available, and options abound in terms of market indexes to track.
Difference between index mutual funds and ETFs
There are also differences between index mutual funds and ETFs:
- How they’re traded. ETFs are traded on stock exchanges during regular trading hours, while mutual funds are traded just once at the end of each trading day.
- Minimum and ongoing investments. Mutual funds may have an initial minimum investment requirement. Investors can then purchase additional shares for a specific dollar amount regardless of the share price. With ETFs, investors may only need to buy a single share. They may need to purchase entire shares after that, although some brokers may offer fractional shares of ETFs.
- Fees. In addition to expense ratios, some mutual funds charge commissions, also called load fees or 12b-1 fees.
- Taxes. Mutual funds tend to buy and sell underlying assets more often than ETFs, which could lead to additional taxable events.
Factors to consider when making investment decisions
Investors have a lot to consider when deciding where and when to invest their money. Personal financial situations, such as whether they have high-interest debt or an employer match in a retirement account, can certainly be factors, as are the investor’s goals for the money.
Among the most important factors that investors often consider are:
- Risk tolerance. Investors’ risk tolerance describes their preferences for holding risky investments. An investor with a low risk tolerance might prefer a broad index fund over a leveraged index ETF because the latter can lead to larger price swings.
- Time horizon. An investor’s time horizon—when they’ll need the money—can also play into asset preferences and risk tolerance. Investors who need the money soon might want to avoid potentially volatile investments.
- Diversification. Investing in a variety of assets can help limit some types of risk. Investments can be diversified across and within asset classes. For example, one can diversify by investing in bonds and stocks, or in different types of stocks.
FAQs of index funds and ETFs
What is a leveraged ETF?
Leveraged ETFs try to mirror and multiply an underlying benchmark index’s movement. For example, if a 3X leveraged ETF tracks an index that moves up $1, the ETF may increase by $3. However, if the index drops $1, the ETF could drop by $3.
How do ETF dividends work?
If an ETF holds stocks that pay dividends, it may distribute the proceeds to shareholders. Depending on the ETF, investors may receive these dividends quarterly or annually. Some investors may also have the option to automatically reinvest their dividends into the ETF.
What is the SPY ETF?
The SPY ETF, or the SPDR S&P 500ETF Trust, is a popular index ETF that tracks the S&P 500 index. In turn, the S&P 500 tracks 500 large U.S. companies and often stands in for how the stock market is doing.
How can one evaluate index funds that track the same index?
Investors can evaluate index funds based on different criteria, including the funds’ expense ratios and historical tracking errors. The initial minimum investment and availability of index funds in a brokerage or retirement account may also be factors.
The bottom line
ETFs and index mutual funds can offer a low-cost way to invest in a diversified group of assets. However, passive investing does come with risks, and index funds will mirror market declines as well as gains.
Actively managed funds may charge higher fees than index funds. But in exchange, investors could benefit from fund managers’ expertise as they try to outperform—rather than match—market returns. “Ultimately, what's most important is your net take-home,” says Titan’s DeYonker.
