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.
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