ETF vs. Index Fund: Which Is Right for You?

There are strengths, weaknesses, and best-use strategies for both index funds and exchange-traded funds (ETFs). They're similar in a lot of ways, and the terms are used interchangeably by some, but "index funds" typically refer to indexed mutual funds, while "ETFs" can refer to any type of ETF without regard to its holdings, goals, or fee structure.

Keep reading to learn more about how these products differ from each other and which could be right for you.

What's the Difference Between ETFs and Index Funds?

Fund Management Style

While ETFs can come in a wide variety of styles, both index funds and index ETFs fall under the heading of "indexing." Both involve investing in an underlying benchmark index. The primary reason for indexing is that index funds (both index ETFs and index mutual funds) can often beat actively managed funds in the long run.

Unlike actively managed funds, indexing relies on what the investment industry refers to as a passive investing strategy. Passive investments are not designed to outperform the market or a particular benchmark index, and this removes manager risk—the risk or inevitable eventuality that a money manager will make a mistake and end up losing to a benchmark index.

A top-performing actively managed fund might do well in the first few years. It achieves above-average returns, which attracts more investors. Then the assets of the fund grow too large to manage as well as they were managed in the past, and returns begin to shift from above-average to below-average.

Expense Ratios

Passive investments such as index mutual funds and indexed ETFs have extremely low expense ratios compared to actively managed funds. This is another hurdle for the active manager to overcome, and it's difficult to do consistently over time.

Many index funds have expense ratios below 0.20%, and indexed ETFs can have expense ratios even lower, such as 0.10%. Actively managed funds often have expense ratios closer to 1%.

Lower expense ratios can provide a slight edge in returns over index funds for an investor, at least in theory. ETFs can have higher trading costs, however, depending on the brokerage you use.

Price

The primary difference between these two terms is that "index funds" are typically mutual funds, and ETFs are traded like stocks, not mutual funds. This has an impact on the price you pay for the investment.

The price at which you might buy or sell a mutual fund isn't really a price—it's the net asset value (NAV) of the underlying securities. No matter when you place your trade during the day, your trade executes at the fund's NAV at the end of the trading day. If the prices of the securities held within the mutual fund rise or fall during the day, you have no control over the timing of execution of the trade. You get what you get at the end of the day, for better or worse.

ETF traders have the ability to place stock orders. This can help overcome some of the behavioral and pricing risks of day trading. Traders can choose a price at which a trade is executed with a limit order. They can choose a price below the current price and prevent a loss below that chosen price with a stop order. Investors don't have this type of flexible control with mutual funds.

However, since ETF trading is determined by price action rather than NAV, it is possible to pay more for an ETF than the total value of assets held within the ETF. The price of the ETF generally tracks close to the underlying value of securities, but it may not always exactly match.

Which Is Best for You?

ETFs and index funds are similar, but the best option for you will likely come down to trading style.

ETFs May Be Best for You If...

ETFs trade intra-day, like stocks. This can be an advantage if you're able to take advantage of price movements that occur during the day.

You can buy an ETF early in the trading day and capture its positive movement if you believe the market is moving higher and you want to take advantage of that trend. The market can move higher or lower by as much as 1% or more on some days. This presents both risk and opportunity, depending on your accuracy in predicting the trend.

Index Funds May Be Best for You If...

If you don't care about trying to seize upon every opportunity the trading day presents, then you may be best off with index funds. Trading ETFs without learning the ins and outs of how trades work can leave you vulnerable to extra costs.

Part of the tradable aspect of ETFs is the "spread," the difference between the bid and ask price of a security. When ETFs aren't widely traded, the spread becomes wider and the costs of the spread become larger.

Jack Bogle, founder of Vanguard Investments and the pioneer of indexing, had his doubts about ETFs, although Vanguard has a large selection of them. Bogle warned that the popularity of ETFs is largely attributed to marketing by the financial industry. The popularity of ETFs might not be directly correlated to their practicality.

The ability to trade an index like a stock also creates a temptation to trade, which can encourage potentially damaging investing behaviors such as frequent trading with poor market timing.

A Best-of-Both Worlds Option

The index funds vs. ETF debate doesn't have to be an either/or question. It can be smart to consider both.

Fees and expenses are the enemies of the index investor, so the first consideration when choosing between the two is typically the expense ratio. There might also be some investment types where one fund has an advantage over another. An investor who wants to buy an index that closely mirrors the price movement of gold, for instance, will likely best achieve their goal by using the ETF called SPDR Gold Shares (GLD).

Finally, although past performance is no guarantee of future results, historical returns can reveal an index fund or ETF's ability to closely track the underlying index and thus provide an investor with greater potential returns in the future.

The Bottom Line

Choosing between index funds and ETFs is a matter of selecting the appropriate tool for the job. ETFs may offer lower expense ratios and greater flexibility, while index funds simplify a lot of the trading decisions an investor has to make.

An investor can wisely use both. You might choose to use an index mutual fund as a core holding and add ETFs that invest in sectors as satellite holdings to add diversity. Using investment tools for the appropriate purpose can create a synergistic effect where the whole portfolio is greater than the sum of its parts.

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