Once you open a brokerage account or individual retirement account, the next step is to allocate your money into various investments. In addition to stocks, index funds and exchange-traded funds (ETFs) are two of the most common types of investment vehicles to choose from, both of which are collections of individual securities.
This piece explores why you should look into index funds and ETFs while outlining the key differences between them.
What are Index Funds?
An index fund is a type of passive investment fund that tracks the performance of a market index or commodity — like the S&P 500, Dow Jones Industrial Average, or a specific industry sector (e.g., tech or healthcare).
Some of the top examples of index funds include the Fidelity ZERO Large Cap Index ($FNILX) and the Schwab S&P 500 Index Fund ($SWPP).
When you invest in an index fund, you typically bank on steady growth over a period of many years. Index funds do not provide the explosive growth that can come with buying individual stocks — if one company’s stock goes through the roof, the benefit will be diluted.
But on the flip side, one company that crashes and burns won’t devastate your portfolio, so index funds can shield you from market volatility and help you maximize long-term growth.
Whare are Exchange-traded Funds (ETFs)?
ETFs are similar to index funds. They are passive funds that bundle numerous investments like stocks and bonds into one equity.
ETFs can track entire markets or specific segments. For example, you may purchase a fund like the Vanguard S&P 500 ETF, which tracks the overall S&P 500. Or, you may look into something like the Global X SuperDividend ETF, which invests in the top dividend-yielding equity securities across the U.S.
You can find an asset class that aligns with your investment strategy and get a basket of stocks from that segment in one purchase.
Why Invest in Index Funds and ETFs?
Index funds and ETFs provide strong diversification for an investment portfolio, making them attractive assets.
The stock market is volatile and full of risk. Stock prices and other equities constantly rise and fall in value. The more you invest in specific companies, the more exposed you become to risk. If you hold a bunch of shares in one company and it plummets overnight, you could lose a lot of money.
Index mutual funds and ETFs help you dilute this sort of risk. When you invest in index funds and ETFs, you automatically invest in many different companies in a single fund. As a result, you diversify your portfolio — reducing risk and increasing your chances to profit.
How Index Funds and ETFs Compare
As you can see, index funds and ETFs are pretty similar investments. But there are some important differences to note before you jump in and start adding them to your investment portfolio.
The biggest difference between index funds and ETFs is how they are traded.
Index funds can only be bought and sold based on the share price that is established at the end of the trading day. In other words, if you want to buy or sell shares at 12:30 p.m. on a Tuesday, your order will go through when pricing is determined after the market closes.
ETFs, on the other hand, can be traded throughout the trading day, just like stocks — meaning their price can fluctuate depending on the overall market.
This is not a big concern for investors with long-term strategies. However, if you’re looking to capitalize on short-term gains, it’s something to note.
Most index funds and ETFs follow similar management structures, as they are passively managed and do not require the manual oversight of a financial professional.
Aside from saving you money, index funds and ETFs also tend to perform better over time. Once you take fees into account, passive funds tend to outperform actively managed mutual funds.
Index funds and ETFs also eliminate the potential for human error. Oftentimes, mutual fund managers make risky or questionable moves to try and beat the market — and they don’t always pan out. Index funds and ETFs avoid this pitfall.
While many ETFs can be purchased via commission-free trades, not all index funds can. For example, if you want to buy a Vanguard index fund on a site like Fidelity or Schwab, you may have to pay a fee.
It’s not quite as simple as saying that index funds are better than ETFs for growth — or vice versa. It largely depends on the type of fund you invest in and how the market performs.
For example, funds that are centered heavily around high-growth securities may produce more rapid short-term growth than ETFs that are more conservative in nature.
To avoid getting frustrated with the performance of your fund, make sure you take the time to read the fund’s prospectus and understand how it allocates money.
Oftentimes, investors sell funds that appear to be sluggish because they don’t fully understand how they are producing returns. It’s not quite as simple as looking at a graph and making a snap decision. You have to look deep into the fund’s performance metrics to really understand what’s going on.
Minimum Initial Investment
One of the biggest downsides about index funds is that brokers often have larger minimum investment requirements, putting them out of the reach of some investors, especially if you’re trying to spread your money around to a few funds.
For example, Vanguard Dividend Growth Fund Investor (VDIGX) is one of the top-performing index funds on the market. At the time of writing, the fund has a minimum entry of $3,000. So look around and find a fund that matches not only your investing style, but also your financial situation.
ETFs typically come with lower minimum investment requirements than index funds. If you can afford the price that the ETF is trading, you should have no problem purchasing the fund contributing to your diversified portfolio.
The expense ratio of a fund tells you how much of the investment goes toward the actual investment, as opposed to management and other fees. Both ETFs and index funds tend to offer affordable expense ratios, making them attractive options for investors.
One thing to keep in mind when buying ETFs is commission fees. Make sure to work with a broker that offers commission-free trades or you will pay a flat fee every time you buy and sell.
Index funds are notorious for having transaction fees, which can be added any time you buy or sell them. Oftentimes, investors are surprised when they trade an index fund and discover a charge they did not expect.
Again, read the prospectus so that you have a clear understanding of what you’ll be paying for when trading index funds and ETFs.
Capital Gains Taxes
Index funds are generally less tax-efficient for investors. When you redeem an index fund, you have to submit the request from the fund manager. The fund manager then sells securities to produce your cash payment.
Unfortunately, investors often wind up footing the bill when this happens. Net gains from the sale are forwarded along to investors in the fund, resulting in capital gains taxes — even if you don’t personally make any trades.
ETFs don’t have this problem because they are sold to other investors just like stocks. You still have to pay capital gains taxes on ETF transactions but you typically pay less overall than with index funds.
Tips for Managing Index Funds and ETFs
Explore Various Indexes
There are many indexes to explore when searching for funds. For example, you can access funds based on factors like geography, asset type, or business sector. You can also search by company size and capitalization.
Explore the various opportunities available when buying index funds before you make any decisions.
Shop around for different brokers
It’s also a good idea to explore the various brokers on the market.
Your goal should be to find a broker that offers low-cost trading and managing along with a robust, user-friendly platform. There are thousands of stockbrokers in the U.S., with some of the most popular including TD Ameritrade, Schwab, and Robinhood.
As for index funds, look into providers like Vanguard, BlackRock, and Franklin Templeton.
Frequently Asked Questions
How can you tell if an index fund is performing well?
When you buy an index fund, the expectation is that it will perform in line with the underlying index that it’s tracking. However, this does not always happen.
Inspect the target index fund’s returns on its quote page and check to see if its return is aligned with the underlying benchmark. If the fund is consistently behind, it could be an indicator that your money is better off elsewhere.
Does it matter where your ETF is traded?
The majority of ETFs are traded on the New York Stock Exchange (NYSE), while others are traded on the NASDAQ. However, it does not matter to investors where ETFs are traded.
Here’s some investment advice that bears repeating: Spend more time looking into the brokerage provider that you’re using to buy ETFs to make sure you’re not paying too much in fees.
Should you use a brokerage or IRA to buy ETFs and index funds?
Most investors choose to use tax-friendly retirement accounts like IRAs and individual brokerage accounts to buy ETFs and index funds. What you do should ultimately coincide with your larger financial goals.
For example, if you’re saving up for retirement, it’s a good idea to put your funds into a tax-free or tax-deferred IRA. If you’re looking to invest in funds to buy a house or launch a business, you’ll want to keep the funds in a brokerage account where you can liquidate them if needed without getting penalized by the IRS for early withdrawals.
What are mutual funds?
Mutual funds are another type of fund offering baskets or collections of securities.
The main difference between a mutual fund and an index fund is that mutual funds have portfolio managers who add and remove select companies in an effort to improve the fund’s performance. This investment strategy is called active management. It’s typically more expensive for investors and it does not always lead to better results.
If you’re on the fence about whether to buy mutual funds, consider talking to a financial advisor to gain an expert opinion. A financial advisor can look at your portfolio and make recommendations based on your risk tolerance and financial position. But be careful — some folks could be incentivized to move you into a particular fund.
Is it better to have a fund manager?
Fund managers — who are typically associated with mutual funds — often do more harm than good for investors. Mutual funds are naturally riskier than index funds because they involve making adjustments to try and beat the market. Managers can sometimes make poor decisions, causing the fund they oversee to underperform.
At the same time, a fund manager could potentially make a small tweak that could lead to sizable gains. It all depends on the type of fund that’s being managed and the manager’s knowledge and experience.
Either way, keep in mind that they will charge a fee for that management, and every dollar that goes into their pocket is a dollar that’s not building returns for you.
The Bottom Line
At the end of the day, index funds and ETFs are two low-risk investments that all investors should look into.
By adding index funds and ETFs to your portfolio, you can reduce risks and increase your overall earning potential in the stock market. Both offer a great way to access many companies at one time, making them perfect for beginner investors and experienced investors alike.
Here’s to adding the best index funds and ETFs to your portfolio and achieving financial independence!