Key takeaways:
Exchange-traded funds (ETFs) and index funds provide a simple way to diversify your investment portfolio. Both types of funds generally have low fees, with index funds often being cheaper. Index mutual funds are commonly found in workplace retirement plans, while ETFs are usually purchased through a brokerage account. Both ETFs and index funds are effective tools for building wealth and are ideal for the average investor, offering diversified and low-cost investment options. Here, we will compare these two types of investments to help you determine if either, or both, are suitable for you.
Differences between ETFs and index funds:
ETFs and index funds have some variations that investors should be aware of.
Where to buy: Index mutual funds are typically available in employer-sponsored retirement plans, while ETFs can be purchased through an IRA, Roth IRA, or brokerage account. Online brokers offer the most options for buying index funds.
Investment minimums: Mutual funds may have minimum investment requirements, while ETFs often allow for the purchase of as little as one share or even fractional shares.
Trading fees: ETFs and index funds have different fee structures, with ETFs usually having lower trading fees. Index mutual funds may have load fees, whereas ETFs do not.
Tax strategy: ETFs are generally more tax-efficient than index mutual funds, as capital gains taxes are incurred only by the seller in ETF transactions.
In summary, both ETFs and index funds are valuable investment options, each with its own advantages and considerations for investors to weigh.
Index funds and ETFs are quite similar and can fulfill similar roles for investors. One key advantage of both is the ease with which they allow you to diversify your portfolio. For instance, total stock market funds track the performance of nearly 4,000 U.S. companies. Vanguard offers VTSAX as a mutual fund and VTI as an ETF, both tracking the same index.
Fees are another area where index funds and ETFs shine, with their costs being notably lower compared to actively managed funds. The passive approach of tracking an index helps keep expenses minimal. In 2023, the average expense ratio for index equity mutual funds was 0.05%, and for equity ETFs it was 0.15%. In contrast, actively managed mutual funds and ETFs had average fees of 0.65% and 0.43%, respectively.
Index funds and most ETFs follow a passive investment strategy by replicating an index’s performance, avoiding active trading to beat the market. This passive approach, combined with low fees, makes them attractive long-term investments.
While index funds and ETFs have shown strong long-term performance historically, deciding between them can be challenging. The choice may depend on specific funds and investor goals. ETFs offer trading flexibility and lower fees, whereas index mutual funds might require minimum investments and limit trading to once a day. Ultimately, both serve as vehicles for investing in securities, such as stocks and bonds, and can yield similar returns over time if tracking the same index with comparable fees.
Getting Started with Investing: Whether you opt for an ETF or an index fund, you’re making a commitment to your financial future. While there are some differences between the two, they are often quite similar. Ultimately, the decision between them is not as crucial as simply taking the first step towards investing. By doing so, you can benefit from low fees, diversification, and the potential for long-term growth in your investments.
