Index Fund vs. ETF: An Overview

Exchange-traded funds (ETFs) and index funds are similar in many ways but ETFs are considered to be more convenient to enter or exit. They can be traded more easily than index funds and traditional mutual funds, similar to how common stocks are traded on a stock exchange. Investors can also buy ETFs in smaller sizes and with fewer hurdles than mutual funds. They can avoid the special accounts and documentation required for mutual funds by purchasing ETFs.

Index Mutual Funds

Index funds are funds that represent a theoretical segment of the market. They're designed to act as the performance and make-up of a financial market index. You can't invest in an index itself but you can invest in an index fund. You're utilizing a form of passive investing that sets rules by which stocks are included and then tracks the stocks without trying to beat them.

These types of funds follow a benchmark index like the Nasdaq 100 or S&P 500. Index funds have lower expenses and fees than funds that are actively managed.

Exchange-Traded Funds (ETFs)

ETFs are baskets of assets that are traded like securities. They can be bought and sold on an open exchange just like regular stocks. Mutual funds are only priced at the end of the day.

Other differences between mutual funds and ETFs relate to the costs associated with each. There are typically no shareholder transaction costs for mutual funds. Costs such as taxation and management fees, however, are lower for ETFs. Most passive retail investors choose index mutual funds over ETFs based on cost comparisons between the two. Passive institutional investors tend to prefer ETFs.

Financial experts consider index fund investing to be a rather passive investment strategy compared to value investing. Value investing often appeals to investors who are persistent and willing to wait for a bargain to come along. Getting stocks at low prices increases the likelihood of earning a profit in the long run. Value investors question a market index and usually avoid popular stocks in hopes of beating the market.

The Bottom Line

Both index mutual funds and ETFs can provide investors with broad, diversified exposure to the stock market, making them good long-term investments suitable for most investors. ETFs may be more accessible and easier to trade for retail investors because they trade like shares of stock on exchanges. They also tend to have lower fees and are more tax-efficient.