Learn what's different about these 2 funds.
Fidelity Smart Money
Key takeaways
- ETFs and index funds pool many investors' money to create large, professionally managed portfolios.
- Both fund types may help simplify investing, tend to keep expense ratios relatively low, and can help reduce risk through diversification.
- ETFs can be bought and sold throughout the trading day, which could make them better for active investors. Index mutual funds can be bought and sold only at the end of the day.
Index funds and exchange-traded funds (ETFs) are 2 simple ways to invest. They're alike in that they both combine many individuals' money into a professionally managed portfolio that could contain stocks, bonds, and other assets. But there are some technical differences between ETFs and certain index funds. Here's how to tell which is right for you.
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ETF vs. index fund: Key differences
The differences between an ETF and an index fund depend on how you define each of those terms. In this article, we're considering an ETF to be a passively managed fund that attempts to mimic the performance of an index, like the S&P 500®. And we're considering an index fund to be a mutual fund that also tracks an index. Really, an index fund could be a mutual fund or an ETF. While most ETFs are index funds, not all are. In fact, an increasing number of ETFs use the same actively managed techniques that many mutual funds do. What follows are the differences between an ETF and an index mutual fund.
Trading access
One major difference between ETFs and index mutual funds is when they can be traded. You can buy and sell ETFs at any time throughout the trading day, just as you can with stocks. Also like stocks, an ETF's price can change during the day based on the performance of the fund's investments.
On the other hand, you can buy or sell shares in index mutual funds only once at the close of each trading day for the price set at 4 p.m. ET. You can put in an order at any time, but it will only go through at the end of the day. At that point, the fund manager will also release the updated index mutual fund share price based on the day's market results.
Investment goals
Whether it's an ETF or a mutual fund, the goal of any index fund is to mimic the results of a specific market index, like the S&P 500®. Most ETFs are passively managed, meaning the assets within the fund simply imitate the index it's tracking. However, there are some active ETFs with different goals, like ones managed by a broker who tries to pick the best-performing stocks within the S&P 500® to earn a potentially higher return.
There's more transparency with ETFs, which typically offer daily portfolio holding disclosures. Index mutual funds only release details on specific investments monthly or quarterly.
Fees
Passive ETFs and mutual funds tend to be low-cost investments. Each charges shareholders an annual fee called an expense ratio. Expense ratio is the total annual fund operating expense ratio from the fund's most recent prospectus. The actual cost to maintain a fund ultimately depends on which company and fund you choose. The Investment Company Institute® found index mutual funds' expense ratios were 0.05% per year on average in 2023, a rate that's been declining for years.1 Index equity ETFs' asset-weighted average expense ratio for 2023 was higher, at 0.15%.2 But there are multiple S&P 500® ETFs that charge 0.03% per year.3 Be sure to check expense ratios before investing because the less you pay in fees each year, the more money that stays in your portfolio. (Psst … Fidelity offers index funds with 0% expense ratios.)
But expense ratios aren't the only fees that show ETFs vs. index funds' differences. With ETFs, you could owe a trading commission, a flat fee each time you buy or sell, depending on your broker (the investment company handling your trades). Some brokers don't charge trading commissions on ETFs though. Other fees and expenses applicable to continued investment are described in the fund's current prospectus. With index mutual funds, brokers could charge a commission and/or a load fee for buying and selling. The load fee could be a flat fee or a percentage of your transaction. Still, there are no-load index mutual funds that don't charge this fee. Other fees and expenses applicable to continued investment are described in the fund's current prospectus.
When you buy and sell ETFs during the trading day, you might also owe something called a bid-ask spread. This means you pay more than the market price to buy and receive less than the market price to sell to compensate the broker for processing your trade. The spread is usually smaller for popular ETFs with high trading volume. Index mutual funds don't charge this spread.
Taxes
Another cost to consider is capital gains taxes, which you're on the hook for if you sell shares of an ETF or an index mutual fund for more than the amount you paid for them.
Index mutual funds could charge an extra tax. If another investor cashes out, the fund manager has to sell portfolio investments to get the investor this cash, owing taxes on any investments sold for a gain. The fund then passes on these taxes to the remaining investors. In other words, you might owe capital gains taxes in a year you haven't sold any index fund shares yourself. ETFs don't owe taxes when investors cash out, making ETFs potentially more tax-efficient than mutual funds.
Minimum investment
ETFs generally don't require a minimum initial investment. You can find index mutual funds with $0 minimum investments, but many do require anywhere from $1 to $3,000 to buy in.
ETFs are usually not an investment option through workplace retirement plans, like a 401(k). If you want to invest through a workplace plan, you might need to stick with index funds and other mutual funds, depending on what your employer offers.
Automation
Some index fund managers offer regular, automatic purchases of their mutual funds, which isn't an option with ETFs.
Index fund vs. ETF: Major similarities
Despite the technical differences between index funds and ETFs, they're similar in many ways.
Simple to manage
With both index funds and ETFs, you make just one purchase to buy into a large professionally managed portfolio. You don't need to buy all of the components of the portfolio individually.
Reduced risk through diversification
Diversification is the practice of spreading your investments around so that your exposure to any one type of asset is limited. It's designed to help reduce the volatility of your portfolio over time. Both ETFs and index funds allow you to spread your money across a portfolio with dozens, if not hundreds, of stocks and other investments, so you can get that diversification.
Strong historical long-term returns
Index funds and ETFs try to match the return of the market or a slice of it. This passive strategy could pay off long term, considering that the S&P 500® has earned a little over 10% a year since 1928, though past performance can't guarantee future results.4 While active ETFs and active mutual funds try to earn higher returns than the market, analysts found only 1 out of 4 active funds outearned the market over a 10-year period ending in June 2022.5 Still, some active funds outperform others.
Should you invest with ETFs or mutual funds?
When choosing what to invest in, focus on the goal of the fund itself and how that aligns with your personal goals. Here are some questions to ask yourself before investing in an ETF vs. index mutual fund.
Do you plan on trading often? ETFs are generally better for frequent trading because you can buy and sell shares throughout the trading day. Index mutual funds only let you buy and sell at the very end of each trading day. ETFs also give you up-to-date information on the fund investment value throughout the trading day. Index funds only release this information after 4 p.m. daily. Lastly, with ETFs, you can buy on margin, a strategy where you borrow money from a broker or bank to invest, and use more advanced order types like stop-limit, when an order is executed at a specified price, and short-sale orders, when an investor borrows securities from a broker, sells them, and then expects to buy them back at a lower price. You don't have these options with index mutual funds.
Do you plan on investing long-term? Index mutual funds could be right for investors in it for the long haul. That's because long-term investors aren't looking to buy or sell throughout the trading day and don't have to worry about minimizing more active plans' transaction costs, though fees vary depending on the fund and who's managing it.
Are you in a higher tax bracket? If you invest outside of a retirement plan, ETFs could be a way to reduce your tax liability. Unlike index mutual funds, ETFs don't trigger capital gains taxes when other investors cash out. In general, both types of passive funds can be good strategies for reducing taxes on your investments.
How to buy ETFs and index funds
The process of investing in ETFs and index funds is similar. First, you need an online investment account with a broker. There are a few factors to consider as you figure out which broker to use, such as what their overall fee structure is and how user-friendly their investment platform is. It's also a good idea to research how diverse their selection is of index funds and ETFs. Some companies offer a wide variety of both, while others are more limited.
Once you have your brokerage account open, you can search through the funds available. Ideally, the platform will detail each fund's goals, fees, and past investment performance. From there you can decide whether the index funds or ETFs are a better fit and then choose specific funds to invest in.
