ETF vs Index Fund - What's the Difference? (2024)

FAQs

ETF vs Index Fund - What's the Difference? ›

The main difference between the two is that ETFs can be traded throughout the trading session, much like a stock, while index fund trades are executed once the market closes. Generally, an ETF will pay dividends if the security (e.g., stock) pays dividends.

The biggest difference between them is that ETFs trade intraday at various prices during exchange hours and index mutual funds can be bought or sold only after the market closes each day, at a fund's net asset value.

Mutual funds are usually actively managed, although passively-managed index funds have become more popular. ETFs are usually passively managed and track a market index or sector sub-index. ETFs can be bought and sold just like stocks, while mutual funds can only be purchased at the end of each trading day.

How are ETFs and mutual funds different? How are they managed? While they can be actively or passively managed by fund managers, most ETFs are passive investments pegged to the performance of a particular index. Mutual funds come in both active and indexed varieties, but most are actively managed.

ETFs tend to be more liquid, have lower net fees, and are more tax efficient than equivalent mutual funds. For those seeking a more active approach to indexing, such as smart-beta, a mutual fund may provide more expert professional management.

And, in general, ETFs tend to be more tax efficient than index mutual funds. You want niche exposure. Specific ETFs focused on particular industries or commodities can give you exposure to market niches.

While an S&P 500 index fund is the most popular index fund, they also exist for different industries, countries and even investment styles.

For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.

Mutual funds and ETFs may hold stocks, bonds, or commodities. Both can track indexes, but ETFs tend to be more cost-effective and liquid since they trade on exchanges like shares of stock. Mutual funds can offer active management and greater regulatory oversight at a higher cost and only allow transactions once daily.

Do index funds pay dividends? ›

Most index funds pay dividends to their shareholders. Since the index fund tracks a specific index in the market (like the S&P 500), the index fund will also contain a proportionate amount of investments in stocks. For index funds that distribute dividends, many pay them out quarterly or annually.

In terms of safety, neither the mutual fund nor the ETF is safer than the other due to its structure. Safety is determined by what the fund itself owns. Stocks are usually riskier than bonds, and corporate bonds come with somewhat more risk than U.S. government bonds.

Both types of funds offer instant diversification and professional management of fund assets. They both involve less risk (and greater convenience) than investing in individual securities. ETFs are a newer option for investors and they were originally known for having far lower fees than comparable mutual funds.

Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).

For beginners, the vast array of index funds options can be overwhelming. We recommend Vanguard S&P 500 ETF (VOO) (minimum investment: $1; expense Ratio: 0.03%); Invesco QQQ ETF (QQQ) (minimum investment: NA; expense Ratio: 0.2%); and SPDR Dow Jones Industrial Average ETF Trust (DIA).

Because they don't require active management, the fees and the expense ratios of index funds tend to be lower, which means they can often outperform higher-cost funds, even without beating them.

The differences between the two tend to be small; in fact, index funds and ETFs are often (but not always) the same thing. Thus, which one you choose is less important than the choice to start investing. In doing so, you take advantage of low fees and diversification, and an investment that will grow over time.

The choice comes down to what you value most. If you prefer the flexibility of trading intraday and favor lower expense ratios in most instances, go with ETFs. If you worry about the impact of commissions and spreads, go with mutual funds.

One of the ways that investors make money from exchange traded funds (ETFs) is through dividends that are paid to the ETF issuer and then paid on to their investors in proportion to the number of shares each holds.