When it comes to investing, there’s no shortage of asset classes. From stocks to bonds and mutual funds to fixed income, it’s important to understand the ins and outs of different types of investments before you make them so you can find the best choice for you as an investor.
If you find yourself asking questions like are exchange-traded funds (ETFs) the same as mutual funds, or are index funds bad for investors, read on to learn the similarities and differences between ETFs and index funds, and how each type of fund works.
What is an ETF (exchange-traded fund)?
So, what is an ETF? It’s an investment fund that can combine stocks, bonds, commodities and other investment assets. Like mutual funds, ETFs enable investors to pool their money and invest in multiple securities at once. However, unlike mutual funds, they trade on stock exchanges, meaning their market prices fluctuate throughout the day, whereas mutual fund prices are set at the end of each trading day.
Each ETF is an investment company registered with the Securities and Exchange Commission (SEC) that an investment advisor can either actively or passively manage. Hence, there are two main types of ETFs:
- Index-based ETFs are passively managed funds that track indexes like the broad S&P 500 or the small-cap Russell 2000 Index. Advisors construct these funds to closely mirror the underlying benchmark index with minor differences.
- Actively managed ETFs don’t track an index. Instead, these funds have investment goals that aim to outperform a benchmark index or a sector of an index. Advisors work to achieve this by buying and selling assets to constantly reshape the portfolio and its holdings for optimal performance.
How do ETFs work?
ETFs act similarly to mutual funds, with multiple investors pooling funds in order to purchase large amounts of assets in which they share profits or losses. In return, long-term investors hope to see their shares appreciate similarly to a stock, and in some instances, receive dividend payments. Unlike mutual funds, ETFs are traded on stock exchanges, so you can buy and sell them on the best online stock trading platforms. ETFs may even include mutual funds among their holdings.
Depending on the goals of an ETF, investment advisors can design them to track investment strategies, sectors, commodities or other assets. For example, the Energy Select Sector SPDR Fund aims to outperform the S&P 500’s energy sector by investing in a basket of stocks in the energy industry. Among the ETF’s holdings are oil majors like Exxon Mobil, Chevron and ConocoPhillips. Another example would be gold ETFs, which are leveraged toward the precious metal and can include investments in physical gold itself or companies that mine it.
What is an index fund?
Index funds are funds created to mirror the returns of the benchmark index by providing a specific mix of assets that represent the index. Index funds meet their investment goals by using stocks, bonds and derivatives like futures and options to track these indexes.
Some of the well-known indexes that index funds track are the aforementioned S&P 500 and the Russell 2000 Index, as well as the Nasdaq, the Dow Jones Industrial Average and the Wilshire 5000 Total Market Index.
How do index funds work?
Whereas an index measures the performance of a market or submarket, an index fund aims to mirror the performance of an index. They’re often passively managed, meaning a fund’s manager doesn’t need to make many adjustments to the securities as the goal is typically long-term growth mirroring the underlying benchmark index. In most cases, the benchmark index the fund is tracking doesn’t change much over time, and in turn, neither does the index fund itself.
Because there isn’t a lot of trading, index funds have less capital gains tax and lower expense ratios compared to ETFs or other funds. The success of an index fund depends on the market index it tracks.
ETF vs. index fund: What is the difference between an ETF and an index fund?
While ETFs and index funds have a lot in common, there are some differences you should know before deciding which investment is right for you. The main differences between the two include trading fees and trading times, availability of fractional shares, minimum investment requirements and tax efficiencies.
Trading fees and time
You can buy and sell ETFs like stocks through brokerage platforms, and now very few brokerages charge trading fees. Through most online brokerages, there’s no commission for ETFs, which makes them attractive investments for all investors. Some index funds have a sales charge that you pay upfront when you…
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