Which is better index fund or ETF?
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.
Typically, it comes down to preferences related to management fees, shareholder transaction costs, taxation, and other qualitative differences. Despite the lower expense ratios and tax advantages of ETFs, many retail investors (non-professional, individual investors) prefer index mutual funds.
Investing in both index funds and ETFs can be beneficial, as they offer different advantages. While there may be some overlap in the investments they hold, there can still be value in holding both.
Index funds can be an excellent option for beginners stepping into the investment world. They are a simple, cost-effective way to hold a broad range of stocks or bonds that mimic a specific benchmark index, meaning they are diversified.
Since index funds are passively managed, they don't buy and sell individual securities as frequently as actively managed mutual funds do. This reduces their tax liabilities and increases your after-tax returns over time.
Disadvantages of index funds. While index funds do have benefits, they also have drawbacks to understand before investing. An index fund tends to include both high- and low-performing stocks and bonds in the index it's tracking. Any returns you earn would be an average of them all.
ETFs and mutual funds that track an index typically have lower management fees than actively managed ETFs or mutual funds. A mutual fund is priced once a day and all transactions are executed at that price, while the price of an ETF fluctuates throughout the day as it is bought and sold through an exchange.
Investing legend Warren Buffett has said that the average investor need only invest in a broad stock market index to be properly diversified. However, you can easily customize your fund mix if you want additional exposure to specific markets in your portfolio.
ETFs can trade intraday, meaning investors can move in and out of these funds like a stock. Conversely, index funds are priced only at the end of the day, making them less attractive for those looking to make short-term trades. An ETF can be passively managed, or it can be actively managed.
You can't go wrong with either the Vanguard Total Stock Market ETF or the Vanguard S&P 500 ETF. Both offer very low expense ratios and turnover rates, and the difference in their tracking errors is negligible. The overlap in their holdings ensures that you'll get very similar returns going forward.
Why not just invest in index funds?
Indexes are set portfolios. If an investor buys an index fund, they have no control over the individual holdings in the portfolio. You may have specific companies that you like and want to own, such as a favorite bank or food company that you have researched and want to buy.
Ideally, you should stay invested in equity index funds for the long run, i.e., at least 7 years. That is because investing in any equity instrument for the short-term is fraught with risks. And as we saw, the chances of getting positive returns improve when you give time to your investments.
Because the goal of index funds is to mirror the same holdings of whatever index they track, they are naturally diversified and thus hold a lower risk than individual stock holdings. Market indexes tend to have a good track record, too.
It's easy to see why S&P 500 index funds are so popular with the billionaire investor class. The S&P 500 has a long history of delivering strong returns, averaging 9% annually over 150 years. In other words, it's hard to find an investment with a better track record than the U.S. stock market.
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.
The important thing to remember about index funds is that they should be long-term holds. This means that a short-term recession should not affect your investments.
For beginners, the vast array of index funds options can be overwhelming. We recommend Vanguard S&P 500 ETF (VOO) (minimum investment: $1; expense Ratio: 0.03%); Invesco QQQ ETF (QQQ) (minimum investment: NA; expense Ratio: 0.2%); and SPDR Dow Jones Industrial Average ETF Trust (DIA).
The average stock market return is about 10% per year, as measured by the S&P 500 index, but that 10% average rate is reduced by inflation.
That's because your investment gives you access to the broad stock market. Meanwhile, if you only invest in S&P 500 ETFs, you won't beat the broad market. Rather, you can expect your portfolio's performance to be in line with that of the broad market.
For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.
Why is ETF cheaper than index funds?
For most investors, ETF trades take place with other investors, and not with the fund company itself. That means the fund company doesn't have to process your order; doesn't have to mail you the same documents; and doesn't have to go into the market to process your order. Less work = lower costs.
Because ETFs are bought and sold on the open market, the sale of shares from one investor to another does not affect the fund. The sale of ETF shares does not require the fund to liquidate its holdings or generate tax implications from capital gains, keeping costs to investors lower.
At least once a year, funds must pass on any net gains they've realized. As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.
Investing most or all your money in individual stocks is risky and can lead to losing your investment capital. Investing exclusively in index funds is risk averse and offers much less in the way of returns. Ideally, you want to keep most of your investment dollars in safer investments such as index funds.
Investors who buy index funds will not lose all of their investment. That's because they're investments buoyed by hundreds or thousands of underlying securities. As such, they're highly diversified, making it almost impossible for them to reach a value of zero.
