- Readily available in 401(k)s or similar retirement plans.
- Often have lower expense ratios than actively managed mutual funds.
- Usually more tax efficient than actively managed mutual funds.
ETFs vs. Index Funds: Which Are Better?
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Exchange-traded funds (ETFs) and index funds are different types of investments, but they have similarities. In fact, most ETFs could be considered index funds, in that they track a stock or bond index such as the S&P 500, Russell 2000, NASDAQ, and others. However, the term “index fund” usually refers to a type of mutual fund, not an ETF, that also follows a market index. We’ll call them “index mutual funds” for the purposes of this article.
A key difference between an ETF and an index mutual fund is in the way they are bought and sold. ETFs are traded just like stocks, during the trading day while the markets are open, while mutual fund orders can be submitted during the trading day but aren’t actually completed until after the markets close.
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Index mutual funds vs. ETFs: Overview of key differences
There are several differences between ETFs and index mutual funds.
| Characteristic | ETFs | Index mutual funds |
|---|---|---|
Trading rules | Traded during the trading day | Transactions executed at the close of the trading day |
Minimum investment amounts | Can purchase a single share and in some cases fractional shares | Often has a minimum investment amount, such as $500, $1,000, or $3,000 |
Tax efficiency | Generally more tax efficient than mutual funds | Generally less tax efficient than ETFs due to their structure |
401(k) eligibility | Rarely available in 401(k) plans | Frequently offered in 401(k) plans |
Fractional shares | Generally traded as whole shares (though some online brokers trade fractional shares) | Can be traded as fractional shares (as they are purchased by dollar amount) |
What are index mutual funds and how do they work?
Index mutual funds invest passively with the goal of tracking a specific market index. Unlike actively managed mutual funds, where the fund manager buys and sells underlying investments in an effort to outperform the market, the job of an index mutual fund manager is to replicate the holdings and the performance of the fund’s underlying index to the greatest extent possible.
Index mutual funds: Pros and Cons
Pros:
Cons:
- Not designed to and generally will not beat the market.
- Can still generate taxable income in a taxable account, the timing of which investors can’t control.
What are exchange-traded funds (ETFs) and how do they work?
ETFs are similar to index mutual funds in that many are essentially index funds that track a market index. The main difference is that ETFs trade during the business day in the same way as shares of individual stocks. This means that instead of waiting until the end of the trading day to have your buy or sell transaction executed, as with an index mutual fund, you can buy or sell an ETF at any point during the trading day for the prevailing share price at that time.
ETFs: Pros and Cons
Pros:
- Often have a lower expense ratio than similar mutual funds.
- Usually more tax efficient than similar mutual funds.
- No minimum investment beyond the cost of a single share.
Cons:
- Can have a bid-ask spread (the difference between the bidding and asking price), which may result in an additional transaction cost for the buyer.
- Intraday pricing can be volatile and might scare some investors into selling.
What index mutual funds and ETFs have in common
ETFs and index mutual funds have much in common. While not all ETFs track an index, most do. Some commonalities for those that do include:
- Similar returns over time.
- Good portfolio diversification due to the large numbers of underlying holdings in the funds, including stocks and bonds.
- Passive management, which results in low expenses and fees and good tax efficiency
When are ETFs the better investment strategy?
ETFs can offer the following advantages over index mutual funds:
- Generally more tax efficient.
- Allow market orders (such as stop or limit orders).
- No front- or back-end loads (sales charges).
- No minimum investment requirements.
- Easier to build a diversified portfolio across a range of asset classes (by investing in a mix of index and sector ETFs).
Robo-advisors, such as M1 Finance or TradeStation, often use ETFs in their investing algorithms for their clients.
When are index mutual funds the better investment strategy?
An index mutual fund may be a better choice than an ETF in the following situations:
- Investing in workplace retirement plans, such as a 401(k) or 403(b), as they often don’t offer ETFs.
- Employing dollar-cost averaging, as you can often invest automatically on a regular, ongoing basis.
- Purchasing fractional shares, as trades are generally placed by dollar amount rather than number of units.
Learn more about sector ETFs
Not all ETFs follow a passive index investment strategy. For example, sector ETFs invest in the stocks of specific industries. Several major ETF providers, including State Street Global Advisors and Vanguard, offer a number of sector ETFs in the following industries:
- Technology.
- Materials.
- Consumer staples.
- Energy.
- Healthcare.
- Real estate.
- Utilities.
- Communications services.
Sector ETFs make it possible to invest in an entire industry within a single ETF. They may consist of all of the domestic stocks or a basket of global stocks in a particular sector. They are a solid option for an investor who wants to own the shares of several companies in a specific industry without buying individual shares.
TIME Stamp: ETFs and index mutual funds are more alike than different
ETFs and index mutual funds can be excellent ways to build and diversify a portfolio. Both can be low in cost, and there are probably more similarities than differences. You can mix them in the same investment portfolio, though employer-sponsored retirement plans often don’t allow ETFs. Which one makes sense for you will depend on your situation and how you invest.
If you’re unsure, try consulting with a financial advisor. If you’re comfortable managing your own investments, consider JP Morgan’s self-directed investing options.
featured partner
J.P. Morgan Self Directed Investing
featured partner
J.P. Morgan Self Directed Investing
Online trading fees
$0 stock & ETF trades.
$0.65/contract options trades.
$0 mutual funds trades.
Account minimum
$0
Promotion
Get up to $700 when you open & fund an account with qualifying new money. Offer expires 7/19/24.
Disclosure
INVESTMENT AND INSURANCE PRODUCTS ARE: NOT A DEPOSIT • NOT FDIC INSURED • NO BANK GUARANTEE • MAY LOSE VALUE
Frequently asked questions (FAQs)
Are ETFs riskier than index mutual funds?
ETFs are not necessarily more or less risky than index mutual funds. It depends on the makeup of the specific funds you are comparing. If you have an ETF and an index mutual fund that track the same index, the risk level of the two funds should be roughly the same.
Is a Roth IRA an index mutual fund or an ETF?
A Roth IRA is neither an index mutual fund nor an ETF: It’s a retirement account. ETFs and index funds are investments that could be held inside of a Roth IRA as part of your investment strategy for that account.
The information presented here is created independently from the TIME editorial staff. To learn more, see our About page.
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