Key points
- Most ETFs are index funds that mimic a benchmark index.
- Index funds can also be mutual funds, which differ from ETFs in a few ways.
- Actively managed ETFs, which don’t follow an index, are becoming increasingly popular.
Investing in exchange-traded funds and index funds can be a great way to diversify your portfolio, particularly if you want to minimize costs. But comparing them as separate investments can be confusing. Most ETFs are, in fact, index funds.
But index funds can also be mutual funds, which differ from ETFs in several ways. Additionally, actively managed ETFs that don’t track a specific index are becoming increasingly popular, so it’s important to know what you’re getting when you invest in one.
ETFs vs. index funds: An overview
An index fund is a type of mutual fund or ETF that invests in a basket of securities to imitate an underlying benchmark index, such as the S&P 500 or Russell 2000. While some index funds invest in every security included in the underlying index, others invest in just a sample.
An index fund is considered a passive investment because the manager adjusts its holdings only when the underlying index changes. The first index fund was launched as a mutual fund in 1976 by Vanguard founder Jack Bogle, tracking the .
Conversely, ETFs can be traded on major stock exchanges, such as the New York Stock Exchange and Nasdaq. The first ETF, launched in 1993, is an index fund that tracks the .
Index funds make up roughly 94% of the ETF market. But actively managed ETFs have become more popular since a 2019 Securities and Exchange Commission ruling made it easier to create and launch them and approved a new semi-transparent structure.
ETFs vs. index funds: Key differences
Because most ETFs are index funds, it may be helpful to break down the differences between index ETFs and index mutual funds and between index ETFs and actively managed ETFs.
Index ETFs vs. index mutual funds
ETFs can be bought and sold on major stock exchanges. Like stocks, they provide real-time pricing for investors. You can trade anytime the market is open.
Mutual funds, on the other hand, are sold directly to investors by the fund itself rather than on the secondary market. All transactions are processed once a day, after the market closes, based on the fund’s net asset value.
While most ETFs are index funds, most mutual funds are actively managed and don’t follow a specific index.
Here are some other differences between mutual funds and ETFs:
- Minimums: Mutual funds typically require a minimum investment of $500 or more, although some do not have minimums. In contrast, online brokers generally allow investors to buy fractional shares of ETFs for as little as a dollar.
- Fees: Both index ETFs and index mutual funds have low fees. But expense ratios — annual fees that cover a fund’s expenses — may be slightly lower for ETFs than mutual funds. Buying or selling an ETF may result in a commission charge by the broker. But most brokers do not charge commissions on such transactions.
- Order types: Because ETFs trade like stocks, you can use market orders, limit orders, stop orders and short sales. This can give you flexibility with the price at which you buy or sell and allow you to take advantage of price increases and decreases. When you buy or sell a mutual fund, you get the same price as everyone else who traded the fund that day. That said, you can make automatic investments and withdrawals with mutual funds, which isn’t the case with ETFs.
- Tax efficiency: ETFs are more tax efficient than mutual funds, primarily because ETF companies and authorized participants, such as large financial institutions, make in-kind transactions when creating and redeeming ETFs. Trading underlying securities instead of cash results in fewer taxable capital gains for investors. Mutual funds typically don’t use this process.
Index ETFs vs. actively managed ETFs
Index ETFs follow specific benchmark indexes, making changes to their holdings only when their underlying indexes change. Actively managed ETFs are designed to try to beat the market through research, market timing and other strategies.
“For many investors, index investing appears more straightforward and more intuitive than active management,” said Peter Eberle, president and chief investment officer at Castle Funds.
But while index ETFs are the most popular type of ETF, investors are increasingly flocking to active ETFs.
“Year to date, over 70% of all ETF launches have been actively managed products,” said Alison Doyle, head of exchange-traded product listings at Nasdaq. “Also, year to date, over 30% of all flows into equity ETFs have gone into active equity ETFs.”
The differences between index and active ETFs include the following:
- Performance: While the objective for active fund managers is to outperform a designated benchmark, only 37% have managed to do so over the past 15 years, according to Vanguard. In other words, you’re more likely to keep up with the market using an index ETF.
- Fees: Because index ETFs are passively managed, fees are low. The average expense ratio for all ETFs is roughly 0.16%. But actively managed ETFs bring up that figure with an average of 0.69%.
- Asset allocation: Because an index ETF tracks a market index, you typically invest in stocks or bonds. “Actively managed ETFs provide exposure to all different asset classes, from equity to fixed income to options overlay strategies,” Doyle said.
ETFs vs. index funds: Key similarities
It’s also important to understand the similarities between index ETFs and index mutual funds and between index ETFs and active ETFs.
Index ETFs vs. index mutual funds
Both index ETFs and index mutual funds are passive investments, generally resulting in lower costs and better returns than actively managed funds.
Here are some other similarities:
- Diversification: Both ETFs and mutual funds diversify their holdings across dozens, hundreds or thousands of securities. Investing in a fund instead of individual stocks and bonds can reduce your exposure to risk and volatility.
- Low fees: Both index ETFs and index mutual funds charge lower fees than actively managed funds.
- Sustainable gains: Because of their low fees and low turnover, index ETFs and index mutual funds are likely to generate better returns than actively managed funds.
Index ETFs vs. actively managed ETFs
Both index ETFs and actively managed ETFs can be traded on major stock exchanges.
Other similarities include the following:
- Diversification: All ETFs invest in a basket of securities, allowing you to diversify your portfolio without buying individual securities on your own.
- Accessibility: Unlike many mutual funds, ETFs don’t require a minimum investment. You typically can buy fractional shares of your favorite ETF for as little as a dollar, depending on the broker.
Liquidity: You can buy and sell your ETF shares anytime the market is open.
Which should you choose?
When it comes to your investment portfolio, it’s important to consider your financial situation, risk tolerance and goals to determine where to put your money.
If you don’t have much to invest, an ETF will likely be easier to buy than a mutual fund. You’ll also enjoy greater liquidity and potentially lower fees. But mutual funds allow automatic investments and withdrawals, while ETFs do not.
You should also consider whether to pick an index fund or actively managed fund. While index funds are less expensive and more likely to match their underlying benchmark, actively managed funds may offer greater diversification across multiple asset classes and could beat the market.
“Investing in asset classes with indexes can diversify away the risk of picking the wrong investment within an asset class at the cost of potentially missing out on a very strong performer within that asset class,” Eberle said.
Research and compare several options to determine the best fit for you.
Frequently asked questions (FAQs)
Because the vast majority of ETFs are index funds, you’re likely to get that if you pick a random ETF.
Index ETFs are easier to trade than index mutual funds and can offer lower costs and more tax efficiency. But they don’t offer the ability to make automatic investments and withdrawals like index mutual funds. Consider your needs and goals to determine which is better for you.
Yes, if a security held in an ETF pays a dividend, the fund will distribute it to shareholders.
If the fund has held the security for more than 60 days and you have held your shares for more than 60 days, the dividends may be considered qualified, meaning that they qualify for taxation at a lower capital gains tax rate. Nonqualified dividends, on the other hand, are taxed at your ordinary income tax rate.
