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Rather than trying to beat the market, many people choose to be the market by investing in passively managed funds.
Over the long term, passive investment vehicles—like exchange traded funds (ETFs) and index funds—have consistently outperformed the vast majority of active funds, making them great choices for most investors. So what’s the difference between them?
ETF vs Index Fund: Similarities
All index funds and the vast majority of ETFsuse the same strategy: Passive index investing. This approach seeks to passively replicate the performance of an underlying index, providing easy diversification and sustainable long-term returns.
Index funds and ETFs provide a simple way to diversify your portfolio. Both offer exposure to hundreds or even thousands of securities, depending on the index they emulate. This can greatly decrease the likelihood your portfolio will be adversely impacted by big market swings.
Prices of individual stocks may swing wildly day to day, but the loses or gains less than 1% per day, on average. Investing in an index fund or an ETF that tracks the S&P 500 doesn’t protect you from all or any losses, but it does reduce the risks and volatility you’d experience if you only held a few individual stocks.
Sustainable Long-Term Gains
Broad-based, passively managed ETFs and index funds have outperformed actively managed mutual funds over the long term.
An elite minority of active managers may deliver impressive results over shorter periods of time by picking individual securities, but it’s exceedingly rare that they can sustain a winning record over decades. In fact, over the past 15 years, more than 87% of actively managed funds have underperformed their benchmarks, according S&P Global.
What does that mean for your investment in an index fund or ETF? Over the long term, the S&P 500 has seen average annual returns of about 10%. You won’t get that number every year—some years it’ll be higher; some years it’ll be lower—but on average, it’s enough to double your money every 7.2 years or so.
Index funds and index ETFs generally have much lower expense ratios than actively managed funds. The Investment Company Institute’s latest survey of expense ratios looked at the average expense ratios of actively managed equity mutual funds versus index equity funds and index equity ETFs.
- Actively managed equity mutual funds charged an average of around 0.74%.
- Equity index funds charged an average expense ratio of 0.07%.
- Equity index ETFs charged an average expense ratio of 0.18%. (It’s not uncommon to see index ETFs with much lower expense ratios, though.)
While they may seem insignificant, expense ratios can really eat into your total returns over time. Assuming you invested $6,000 a year for 30 years and saw an average annual return of 6%, investing in the average index mutual fund would save you almost $60,000 over the cost of the average actively managed mutual fund.
Indexed, passive investing reduces your overall costs and leaves more of your money at work in your portfolio.
ETF vs Index Fund: Differences
One of the most significant differences between an index fund and an ETFs is how they trade. Shares of ETFs trade like stocks; they’re bought and sold whenever markets are open. While you can order index fund shares whenever you wish, share purchases only happen once a day, after the markets close. This means that the price of any given ETF fluctuates throughout the trading day, while the price of an index fund only changes once a day.
While both index funds and ETFs charge low expense ratios, additional fees beyond the expense ratio may look very different.
Most brokers have eliminated trading commissions on nearly all stock trades, and many charge no commission for ETF trades, either. Meanwhile, a broker’s sales commissions for index funds can be very expensive. That said, online brokers generally offer a selection of commission-free funds. There’s just no guarantee that the funds you want to buy are free of commissions.
Then there are load fees, another form of sales commission. Front-end load fees may be charged for buying funds while back-end load fees may be charged for selling funds. Load fees can be a percentage of your total purchase or a flat fee. ETFs lack load fees entirely.
So a given ETF may charge a higher annual expense ratio than an index fund you have your eye on, but you need to take into account the potential commissions and sales load fees charged by a comparable index fund.
Minimum Investment Amounts
Many index funds have minimum investment requirements, sometimes in the thousands of dollars. ETFs have no minimum purchase requirements.
While some index fund providers have lower minimums if you set up regular contributions to a tax-advantaged retirement account, they can still be substantial.
Until recently, most ETFs were not available as fractional shares (depending on your brokerage, they still might not be). Index funds, on the other hand, have always been available in fractional amounts.
When you buy into an index fund, managers convert the dollar value of your investment into the correct number of shares based on the NAV the day of your purchase, regardless of whether you end up with a fractional share or not.
Fractional shares have the potential to help you get your money in the market sooner by letting you buy parts of full shares of funds instead of purchasing full, pricier shares. This also lets you better take advantage of dollar-cost averaging, which may help you pay less per share overall over time.
ETFs are generally more tax efficient than mutual funds. While you will pay capital gains taxes on any gains you realize when you sell shares of an index fund or an ETF, you do not pay taxes when the holdings in the ETF portfolio are adjusted by managers.
Index funds, on the other hand, must buy and sell assets to adjust their portfolio to track the underlying index. The cost of any capital gains taxes from these sales are taken out of the fund portfolio NAV, which impacts the value of your index fund shares. That said, index fund holdings rarely change, so this may not be a huge issue for you.
ETFs are very seldom available as investment options in defined contribution plans, like 401(k)s. Generally, index funds and actively managed mutual funds are your only choice. When index fund and mutual fund shares are purchased in a retirement plan, there generally aren’t minimum minimum purchase requirements.
If you save for retirement in an IRA, you’ll have access to a very wide range of ETFs and index funds. If you invest extra funds in a taxable investment account via an online brokerage, you’ll probably have access to all available funds and ETFs. In this case, minimum investment amounts and the availability of fractional shares may impact your choice of ETF vs index fund.
Should You Invest in ETFs or Mutual Funds?
In the end, the choice of ETF vs index fund is probably less important than the fact that you’re decided to invest for your long-term goals using a passive investing vehicle. Whether you choose an index ETF or index mutual fund, you’ll benefit from lower fees, diversification and historically superior performance of index-based investing.
As an investment enthusiast with extensive knowledge in passive investing and financial markets, let's delve into the concepts presented in the article and shed light on the nuances of ETFs and index funds.
Passive Index Investing: The core strategy discussed in the article revolves around passive index investing. This approach involves replicating the performance of an underlying index, providing investors with easy diversification and sustainable long-term returns. The focus is on avoiding attempts to beat the market actively and instead opting to be the market.
Diversification: Both index funds and ETFs offer a straightforward method for diversifying a portfolio. By tracking various indices, these investment vehicles expose investors to hundreds or even thousands of securities. Diversification helps mitigate the impact of market volatility, reducing the risks associated with holding individual stocks.
Sustainable Long-Term Gains: The article emphasizes that passively managed ETFs and index funds have consistently outperformed actively managed mutual funds over the long term. This assertion is supported by data, citing that a significant majority of actively managed funds underperform their benchmarks over a 15-year period.
Low Fees: A crucial advantage of passive investing highlighted in the article is the lower expense ratios associated with index funds and ETFs compared to actively managed funds. The data from the Investment Company Institute's survey showcases the significant difference in average expense ratios, emphasizing how lower fees contribute to enhanced total returns over time.
Trading and Trading Fees: One key distinction between ETFs and index funds is their trading mechanism. ETFs, trading like stocks, can be bought and sold throughout the trading day, causing their prices to fluctuate. In contrast, index fund share purchases occur once a day, after markets close. Additionally, the article points out the differences in trading fees, emphasizing that many brokers have eliminated trading commissions for ETFs but may charge commissions for index fund trades.
Minimum Investment Amounts: Another factor discussed is the minimum investment requirements. While index funds may have minimum investment amounts, ETFs generally have no such requirements. The article notes that some index fund providers offer lower minimums with regular contributions to retirement accounts.
Fractional Shares: The availability of fractional shares is highlighted as a feature more commonly associated with index funds than ETFs. Fractional shares allow investors to invest smaller amounts, potentially aiding in getting money into the market sooner and leveraging dollar-cost averaging.
Tax Implications: The article underscores the tax efficiency of ETFs compared to mutual funds. ETFs tend to be more tax-efficient due to their unique structure, with capital gains taxes incurred only when selling shares. On the other hand, index funds may generate capital gains taxes as they adjust their portfolios to track the underlying index.
Availability: The article touches upon the limited availability of ETFs in defined contribution plans like 401(k)s, where index funds and actively managed mutual funds are typically the primary options. Availability of ETFs and index funds in retirement plans and taxable investment accounts is discussed, with factors like minimum investment amounts and fractional shares potentially influencing the choice between the two.
In conclusion, whether an investor chooses an ETF or an index fund, the overarching decision to embrace passive investing for long-term goals remains the key takeaway. Lower fees, diversification, and historically superior performance of index-based investing are the common benefits highlighted for both ETFs and index funds.