Comparing ETF Vs. Index Fund: Which Is Right For You?

When building a portfolio, there are many ways to invest your money. But if you’re looking for a simple way to get broad market exposure at a low cost, you might want to consider ETFs vs. index funds. While both of these investment vehicles can help you capture the benefits of diversification at a reasonable price, they also have some important differences that you should take into consideration when choosing which one is right for you. Both ETFs and index funds generally have very low management fees (around 0.2% per year), which makes them ideal for investors who want to keep their costs as low as possible. Both also tend to be more tax-efficient than other mutual funds because they trade less often and don’t have an expiration date. That being said, there are some key distinctions that you must be aware of before making your decision regarding ETF vs. index fund.

What’s the difference between an ETF vs. an index fund?

An ETF (Exchange-Traded Fund) is an investment fund that owns assets such as stocks, bonds, or other commodities and then distributes redeemable shares of those assets based on their current value. On the other hand, Index funds passively track a given index (i.e., S&P 500, Russell 2000) by buying the components within that index in the same proportion as they appear. So, whereas an index fund will simply attempt to mirror the return of a particular index, an ETF will also attempt to mirror the return of that index, plus any capital gains generated by the fund’s holdings. That’s because ETFs are actively managed, meaning that fund managers actively buy and sell securities to track the performance of an index. In contrast, an index fund manager will typically use an indexed portfolio fully invested in the fund’s holdings, with minimal trading activity.

How to decide: Is cost efficiency most important?

Both ETFs and index funds have very low management fees. Still, ETFs tend to have lower annual expense ratios because they are actively managed. That means that fund managers are constantly buying and selling securities in order to keep the fund’s holdings in line with the fund’s stated objective. In contrast, index funds are fully invested in the fund’s holdings, with minimal trading activity. This means ETFs are generally more tax-efficient than index funds since they have fewer taxable events. One way to evaluate this is by looking at what’s called the “rebalancing” of the fund. An actively managed fund will have to sell and buy shares of an underlying asset more frequently than an index fund in order to remain consistent with the fund’s stated objective, which means it will have a greater chance of generating taxable events.

Is tax efficiency most important?

Suppose you’re mainly interested in minimizing taxable events and value simplicity. In that case, you might want to go with an index fund. Because index funds hold all of their assets at once, you won’t have to deal with any taxable events as a result of buy/sell activity within the fund. Of course, the flip side is that the fund won’t be rebalanced, so you may miss out on potential gains from selling assets within the fund at a profit. Index funds are a good choice if you’re looking for a low-cost, tax-efficient investment with minimal hassle.

Are you averse to risk?

If you’re uncomfortable taking on any risk, index funds are generally better than ETFs. That’s because most ETFs are actively managed, which means that the fund managers will attempt to outperform the index to which it’s tied. Suppose you’re looking for a way to hedge against market volatility. In that case, you might want to invest in an index fund that tracks a broad-market index (i.e., S&P 500). ETFs are generally riskier than index funds because fund managers are actively attempting to outperform an index. That means they will attempt to buy different securities than those tracked by the index to increase their fund’s performance. This round goes to index funds in the ETF vs. index funds matchup.

How to decide: Are you mainly investing for growth?

Suppose you’re primarily interested in growing your capital as efficiently as possible. In that case, ETFs might be better than index funds. That’s because ETFs are actively managed and will attempt to outperform the index by buying different securities than those tracked by the index. However, index funds can also add value to your portfolio if you choose an appropriate index. For example, S&P 500 is a broad-market index that includes 500 U.S. stocks. A balanced index like the Russell 3000 attempts to mirror the performance of approximately 98% of the U.S. equity market. But if you want to guarantee that your fund will outperform the market, you’ll need to go with an actively managed ETF. That’s because index funds always track the performance of the index to which they’re tied. So, no matter which index you choose, you can be certain that the fund’s performance will be nearly identical.

Is brand reputation most important?

If you’re looking for a reputable fund manager and a fund that has been around for a while, you might want to go with an ETF. While many index funds are also reliable, ETFs are actively managed and are typically tied to more recognizable brands. Additionally, ETFs have the reputation of being more timely than index funds. This means that fund managers can make adjustments to the fund more quickly if there’s a need to rebalance the holdings in the fund. On the other hand, Index funds are passively managed, so the fund manager doesn’t care about the price of any holding. In terms of ETF vs. index funds, the former won this section.

Conclusion

When building a portfolio, there are many ways to invest your money. But if you’re looking for a simple way to get broad market exposure at a low cost, you might want to consider ETFs or index funds. While both of these investment vehicles can help you capture the benefits of diversification at a reasonable price, they also have some important differences that you should take into consideration when choosing which one is right for you. That being said, there are some key distinctions that you must be aware of before making your decision. Depending on your investment goals, you might find that one type of investment is more appropriate than the other when looking at ETF vs. index funds.