How to Choose Between Index Funds and ETFs

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When you’re fairly new to investing in the stock market, you’ll need to put some effort into learning some key terminology. Let’s assume you’re a retail investor, not an institutional investor, so you’ll want to determine your best bet for long-term results in your investments. Here are some useful guidelines for how to choose between index funds and ETFs. 

If you’re planning on investing to make money on a day-to-day basis, that’s a lot more complicated. But for the more common purpose, a vast majority of us are investing for retirement. When creating your investment portfolio, you might build much of it from index funds or ETFs.

What is an Index Fund?

An index fund is meant to be a representation of a segment of the entire stock market. It’s actually a mutual fund that tracks a stock market index. 

Basically, there are thousands of different stock market indexes worldwide, with about 5,000 in this country. The U.S. has three main stock market indexes that the majority of people tend to follow. We look to these indexes to gauge the health of the economy and make investment decisions. 

Three top indexes the media emphasizes in the U.S.:

  • S&P 500
  • Dow Jones Industrial Average
  • Nasdaq Composite

Jack Bogle, who founded the Vanguard Group, conceived of the first-ever index fund in 1976. It was a way to mimic the performance of the stock market without the high expenses of a mutual fund. The way his new index worked was intended to pass on savings to everyday retail investors. 

Now, the index fund eventually expanded to include ETFs, which didn’t make Bogle very happy. We’ll get into the reasons for his disapproval of ETFs in a little bit. 

What Is An ETF?

ETF stands for exchange-traded fund. The creator of an ETF will select a number of securities to include in the fund. They might center around a particular industry or region or sector, which can appeal to certain investors. 

An ETF isn’t always only made up of stocks, but can include bonds, commodities, or currencies as well. These enable people to buy shares in companies that aren’t as widely available as those on the common indexes. 

Here are some of the common types of ETFs:

  • Market ETFs (these track an index like Nasdaq or S&P 500)
  • Bond ETFs
  • Commodity ETFs (think gold, corn, oil)
  • Style ETFs (tracking an investment style like large-cap value; small-cap growth)
  • Foreign market ETFs
  • Inverse ETFs
  • Alternative Investment ETFs

What Kind of Investor Are You? 

Before investing in either ETFs or index funds, try to narrow down the type of investor you’re going to be. How actively involved do you want to be? Are you interested in primarily long-term trading, or do you anticipate trading multiple times in a day? And how much money do you have to start with?

Index Funds and ETFs: Key Similarities

One thing that’s good to recognize is that index funds and ETFs are quite similar in a few respects. Both of them are passively-managed investments. They enable the average individual investor to do a little reading up early on before setting an investment strategy. Take a look at some of the main things index funds have in common with ETFs.

  • diversification of investments
  • low cost
  • passively managed
  • good for long-term investing

Index Funds and ETFs both provide diversification

Whether you invest mainly in index funds or ETFs, you can be confident you’re getting baked-in investment diversification. Diversifying your investment portfolio is essential, as it lets you ride out any downturns affecting one industry or sector. 

Investments increase and decrease in value over time; that’s the nature of the beast. By intentionally diversifying to include investments in multiple different areas, you’ll be better prepared to ride out storms. 

Since with both index funds and ETFs, you hold many different stocks or securities, you’re less likely to lose money. Even if some stocks are down at one point, many others will shoot up in value.  

If you go with index funds, you’ll own shares in all the companies included on that specific index. So when some stocks go up in value, whether due to a tweet or a larger market event, others will go down. When one stock skyrockets, others will drop. 

The same is true for ETFs. They’re described as a “basket” of securities, so investors can get a piece of a bunch of companies within one asset class. However, you avoid putting “all your eggs in one basket” or all your money into one investment vehicle. 

Low expenses with both options

It used to be that investors had to pay a full-service brokerage firm to manage their portfolios. That service didn’t come cheap, and still doesn’t. 

However, one terrific change to investing (thanks, John Bogle, among others!) is cheaper options. Nowadays, the average retail investor can build a diversified and smart portfolio while enjoying extremely low fees. 

Both index funds and ETFs offer super-low fees. Many investment robo-advisors like Betterment even give zero-commission trades to clients as a standard now. That’s always important, but especially if trading frequently. Remember there may be other charges for maintaining your account each year as well as other fees. 

Passive management

Both index funds and ETFs are considered strong investments for those who want a passively managed strategy. These are for you if you don’t want to spend an enormous amount of time debating over your investments. You want to do some initial research, settle on a strategy, and automate your plans. 

True, people who spend more time picking investments and making frequent trades have a shot at making big paydays. However, for the average investor, actively investing constantly is unlikely to yield awesome long-term results. Sticking with passively managed funds is a more tried-and-true tactic for someone investing for many years. Actively-managed mutual funds could be great in the short-term, but difficult to maintain great returns over time.

Index Funds and ETFs: Key Differences

Making the decision between index funds and ETFs doesn’t have to be that complicated. There are not a ton of differences, but it’s good to recognize the ones that exist. 

  • How often can you trade in a day with either choice?
  • What’s the cost to start investing in an index fund versus an ETF?
  • Are there tax implications to consider with either type of investment?

How often can you trade with index funds vs. ETFs?

The trading frequency is what John Bogle hated about ETFs, and why he didn’t advise anyone to invest in them. In a 2016 interview, Bogle mocked those who trade constantly all day in real time: “What kind of a nut would do that?” 

ETFs provide investors the option of enacting multiple trades in a single trading day. You can buy and sell shares of stocks in real-time, locking in the price at that moment. 

(That’s why ETFs are awfully appealing to some people; they can make good returns with well-timed trades. Buy low, then sell high.)

Although some people make money day trading, it’s a bit of a gamble. As Bogle said, “We all think we’re smarter than the other guy…but we’re all average.” A good piece of wisdom to remember. 

The original non-ETF index funds mean no matter when you place your trade order, you still get the stock price at day’s end. So there’s less flexibility with index fund trading; you normally wouldn’t try buying or selling frequently, and definitely not multiple times a day. 

So the bottom line with this issue is, if you really want to trade frequently, ETFs are probably the way to go. If you’re going to “set it and forget it” you might stick with index funds. 

How much to start investing with index funds and ETFs?

Of course, the costs of having a brokerage account with these types of investments are already fairly low. You generally only pay a small fee to hold the account and then no commissions on trades. Expense ratios tend to be very reasonable on both index funds and ETFs.

It’s also good to consider the initial cost of setting up an index fund investment or ETF. Index funds sometimes come with a higher barrier to entry. For example, Vanguard requires a $3,000 minimum initial deposit to start an index fund. 

While this may seem insignificant, for a beginner investor, coming up with several thousand dollars can be daunting. If that’s the case, you can start investing in ETFs for the cost of one share of stock. Better to get your investments going right away, rather than wait for enough cash for the index fund. 

You can also check some online brokerages; they might allow you to open an index fund without a large initial deposit. 

Which one is better for tax purposes?

Typically, ETFs will win in a debate about tax efficiency of index funds vs. ETFs. It’s possible with index funds to end up owing capital gains taxes even if you don’t sell shares. Fidelity says “ETFs can be more tax efficient compared to traditional mutual funds.” 

The way ETFs are structured means you often pay less in taxes from ETF after selling shares and incurring capital gains. You sell shares in an ETF to one investor and pay the capital gains taxes yourself. 

Which Investment Type Is Best For You?

Generally speaking, most of us can’t go wrong owning either index funds or ETFs. They’re both strong contenders in the long game of investing for your future, helping grow your money for you. 

No matter what investment vehicle you choose, do your homework. Check out brokerages and expense ratios for all types of index funds and ETFs you’re considering. Compare their average annual returns. Know the fees you may pay at the time of trading as well as for holding the account long-term.