Wondering what is the difference between ETFs and index funds? This article explains that and more, including what to look out for when choosing between them. Index funds and ETFs (Exchange-traded Funds) are often mentioned together in discussions about popular investments, which can lead to the notion that both of them are one and the same. That is not entirely inaccurate. At their cores, index funds and ETFs indeed do share several similarities. For one, they are popular types of investment funds. For another, both ETFs and index funds come in many different flavours.
However, they also have distinct differences, which can potentially make one more suitable than the other, depending on your trading and investment style. Here’s an in-depth look at index funds vs ETFs that will hopefully help you decide which one to choose.
Understanding investment funds
Before we get into the nitty gritty of things, let’s set the stage with a brief primer on investment funds. An investment fund is simply a fund pooled together using money from several different investors, and then invested. Just like you are free to invest your own savings into any investment product you choose, an investment fund is also at liberty to invest in any number of securities – or pursue any combination of investment styles and theses, for that matter – in accordance with a stated investment objective.
As such, there are many different types of investment funds, including:
- Real estate investment trusts (REITs)
- Hedge funds
- Bond funds
- Index funds
- Mutual funds
- ETFs
For the purpose of this article, we’ll be focusing on the last three in the list. But the key takeaway here is that ETFs, mutual funds, and index funds are different types of investment funds.
What is an ETF?
An ETF is a type of investment fund that tracks an underlying basket of securities. There are many different types of ETFs available that track different types of securities, such as equities, bonds, commodities, and cryptocurrencies. Besides asset classes, ETFs may also be structured along other lines, including sectors, market capitalisation, countries, or geographic regions, and even investment styles.
There are also ETFs that track a specific market index, such as the S&P 500, or the Nasdaq. These types of ETFs are also known as index ETFs, and some consider them to be a type of index fund.
What is an index fund?
By definition, an index fund is any investment fund that tracks the performance of a particular market index. You’ll recall that index ETFs fit this description, but they are not the only investment funds that do. Many (but not all) mutual funds also track the performance of an underlying index, and these are sometimes known – confusingly – as index mutual funds, or just index funds. Why does this matter? Well, because ETFs and mutual funds are traded differently, and it is this difference that an investor should pay attention to (we’ll get into more detail in a second).
So, second key takeaway: When someone talks about an index fund, it is important to clarify which type they are talking about – index ETF or index mutual fund.
For the rest of this article, when you see ‘index fund’, know that we are referring to mutual funds that track an underlying market index.
At-a-glance: Index fund vs ETF
| Index fund | ETF |
| Tracks the performance of an underlying index | May track any number of securities, including indices and derivatives |
| Traded only once a day | Tradeable at any time throughout the trading day |
| No bid-ask spread, always traded at net asset value | Trades subject to bid-ask spread |
| May have a sales charge | Sales commissions may be charged |
| Likely to have lower expense ratio than other mutual funds | Expense ratio varies according to fund management style (passive or active) |
| Offers diversification according to index tracked | Offers diversification according to underlying securities |
Differences between ETFs and index funds
Liquidity
The main difference between an ETF and an index fund is the frequency of trading. ETFs are exactly as the name implies – funds that are traded on exchanges. ETFs may be traded multiple times throughout the trading day, whereas index funds are only traded once each day. As a result, ETFs offer a higher degree of flexibility and liquidity to investors, allowing them to buy and sell on the market during the trading day. Index funds are seen to be less flexible in this regard, as any trade you initiate will be held until trading closes.
Fees and expenses
Similar to common stocks, ETFs are bought and sold on an exchange through a broker. You will be charged a commission each time you buy or sell an ETF, although some online brokerages offer zero-commission ETF trading. Also, like stocks, ETFs are subject to a ‘bid-ask spread’, which is the difference between the price a buyer is willing to pay versus the price a seller is willing to sell at.
Meanwhile, index funds are bought and sold directly from the fund manager and done so only at the close of the trading day. As such, there is no bid-ask spread involved. However, some mutual funds have a sales charge – due at the time of purchase (front load) or at the time of sale (back load).
Minimum investment required
ETFs do not normally require a minimum investment sum, and you can start investing in them with any budget, large or small. Similarly, some index funds may also allow you to start investing without having to fulfil a minimum investment sum. However, many retail index funds come with a minimum investment sum of between USD500 to USD5,000.
Similarities between ETFs and index funds
Diversification
Given the sheer variety of securities and assets available, ETFs and index funds both make for a convenient and easy way for investors and traders to diversify their investment holdings. A portfolio with multiple ETFs and mutual funds based around a mix of different asset classes, geographical regions, market capitalizations and investing styles is likely to be better diversified – and thus more resilient to market shocks – than a portfolio composed of select asset classes.
Low cost (if passively managed)
ETFs and index funds are mostly passively managed and allowed to simply follow the performance of their underlying securities or indices. This lack of upkeep allows ETFs and index funds to have low expense ratios, which translates to lesser costs to investors.
ETF or index fund – factors which can help you make a choice?
When deciding whether you should choose an ETF or an index fund, it boils down to the trading strategy you wish to employ. Because ETFs may be traded throughout the trading day, they are suitable for strategies that focus on intra-day trades, such as day-trading. Furthermore, ETFs can also track financial derivatives of different securities, allowing for a greater range of investment styles to be accommodated. Index funds, on the other hand, are only traded at the end of the day, which means less flexibility in entering and exiting positions.
Additionally, index funds are only traded at the price point set at the end of the trading day, which means there is lesser intra-day volatility in comparison to ETFs. Indeed, index funds tend to be more predictable, but whether this is desirable or not depends on your trading style.
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