ETFs and Index Funds are a great way to begin investing, but what is the difference? This guide breaks down similarities and differences, and will help you decide whether Index Funds or ETFs are the right investment vehicle for you.
Indexing Strategy
The most important similarity between an ETF and an index fund is that they are both part of an indexing strategy, which is one of the many different kinds of investment strategies out that exist.
An indexing investment strategy seeks to mimic the performance of a particular market index. A market index, as defined by Investopedia, is “a hypothetical portfolio of investment holdings that represents a segment of the financial market.” In the U.S., there are three main market indexes: the Dow Jones Industrial Average, the S&P 500, and the NASDAQ Composite Index. Each of these indexes measures a different “segment” of the overall market. The S&P 500 , for example, represents the 500 largest U.S. publicly traded companies.
Since an index investment strategy only seeks to mimic the performance of a given index, we can consider this a passive investment strategy. This means you will not be managing your own portfolio by trading. Essentially, you’re letting the market do its thing and counting on it to keep going up. And if history tells us anything, it’s that the market will, in the end, always be up. This is even more true when we practice a buy and hold strategy (aka indexing strategy).
What Are The Similarities Between Index Funds & ETFs
Whether you choose an ETF or an index fund, both types of investment products will measure certain segments of the larger market.
Ask people in the personal finance/investing sphere on Instagram and you’ll probably get a mix of responses as to whether a passive or active investing strategy has higher returns.
Warren Buffet, though, will tell you this passive form of investing will repeatedly outperform actively managed funds. One big reason is the market’s natural upward mobility over the long term.
Apart from being some of Warren Buffet’s preferences as an investment product, ETFs and index funds also share the following traits:
- They provide diversification
- They have low expense ratios and, potentially, a low buy-in minimum
- With a buy and hold strategy, they have historically outperformed actively managed funds
Index Fund
An index fund is the clearest investment product following an indexing strategy. First thing to know to avoid confusion: it is a type of mutual fund.
Think of a mutual fund as a pool of money that is collected from a lot of investors to then invest in different kinds of securities. Mutual funds have a specific investment objective, such as growth, income, or preservation of capital. They are operated by money managers. And whenever this is the case, there are often higher expense ratios.
However, an index fund is a type of mutual fund that is managed not by a money manager, but by an index. In other words, it tracks a market index. For this reason, index funds usually have significantly lower expense ratios. We’re talking as low as .04%, which is actually Vanguard’s VTSAX’s expense ratio. This index fund tracks the Dow Jones Industrial Average index and stands as one of the pioneer index funds.
ETF
An ETF stands for exchange traded fund. Much like an index fund, an ETF represents a certain sector of the market. Nathaly Minda from The Financial Talk gave an easy to understand analogy during this week’s podcast episode. First, think of a stock as if it’s a fruit. An ETF is a basket of fruit. In this basket, you can have all kinds of fruits, meaning you can have a variety of stocks. While not all ETFs are stock-based, we will stick with these kind for the example
ETFs, like index funds, can track an index. But some are also investing in a certain sector. Examples of sector-based ETFs include:
- Stock ETFs
- Balanced ETFs, which are a blend of stocks and bonds
- Bond ETFs
Stock ETFs can focus on specific industries, such as:
- Real estate sector
- Gaming technology
- Medical products
- Technology
ETFs, like index funds, also have low expense ratios.
What Are The Differences Between Index Funds & ETFs?
Maybe after reading the above, you’re still a little confused over which is the right investment product for you. And while I can’t tell you to go ahead and buy one or the other, I can lay out what each one is and what their differences are. There are two main differences.
1. Method of purchase and selling
While ETFs operate like any other stock that you can trade throughout the market day, index funds can be only bought and sold at end of each trading day (4pm ET).
If you follow an indexing strategy, this won’t really matter, since your strategy is to buy and hold. However, if you trade, then the price at which you buy matters. For this strategy, an ETF is better suited, as you have control over the price you choose to purchase an ETF.
For an index fund, the price that you pay for a share is decided at the end of the trading day at which you placed your order.
2. Buy-in amount
An index fund will typically require a minimum investment. Vanguard’s pioneer index fund, VTSAX, for example, has a $3,000 minimum investment. Once you buy-in, though, you can make regular investments (minimum $100) to continue to purchase more shares. Any amount you contribute to this fund will get you the equivalent portion of a share.
ETFs, on the other hand, have a minimum investment amount that is equivalent to the price of one share. Depending on 1) the dollar amount that you have available to invest, and 2) your comfort level as you start your investing journey, an ETF might seem like a more attractive option.
If you’re asking yourself whether an index fund or an ETF is the type of investment product you should purchase, you’re probably far along in your investing education journey. Maybe you’re even ready to start. At the end of the day, if you’re a long term, buy and hold type of investor, this choice is all about comfortability and interest in specific industries. Only you know yourself best, and after reading this post, you should have a stronger leaning towards one or the other.
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3 Responses
Thanks for helping me understand that index funds would not be managed by a money manager which can usually have a significantly lower expense ratio. I wonder who are the best candidates for this type of investment, since I think you have to be a great match for something to actually be successful, financially. It must be best to talk to professionals and read books to learn how to invest in index funds the right way if you are for this industry to have the a huge chance of achieving success.