ETFs vs. Index Funds: A Simple Guide for New Investors

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What Are ETFs and Index Funds?

As the Securities and Exchange Commission defines them, exchange-traded funds and index funds are investment companies that pool investors’ money to invest in stocks, bonds and other assets. Whereas index funds are a type of mutual fund, ETFs have some features in common with mutual funds but are an entirely different type of asset.

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How Do ETFs Work?

ETFs are baskets of securities selected by professional fund managers to meet certain objectives. They get their name from the way they’re traded — in the open market, on stock exchanges like the New York Stock Exchange or Nasdaq.

ETFs give you a lot of flexibility in that you can buy or sell shares from your brokerage account whenever trading is open, and they’re often themed, so you can invest according to special interests like cryptocurrency or artificial intelligence.

Price Fluctuations

ETF prices might fluctuate throughout the day, just as stock prices do. Your trade goes through at the fund’s market price, which is the price a buyer is willing to pay or a seller is willing to accept.

Actively Managed

Some ETFs are actively managed, which means that managers buy and sell securities in the ETF’s portfolio to maximize the fund’s performance. However, most ETFs are passively managed. Rather than try to try to beat an underlying benchmark, index funds attempt to match it.

Passively Managed

Managers of a passively managed ETF that tracks the S&P 500 index might buy all of the stocks in the S&P 500 or a representative portion of them. That way, when the S&P 500 rises or falls, the ETF’s value rises or falls by the same percentage.

Keep in mind that an ETF is a company in its own right. Your shares give you proportionate ownership of the fund and the income it generates, but you don’t own any of the stocks within the fund. ETFs provide an indirect way to invest in themed collections that match your interests.

How Do Index Funds Work?

Index funds work similarly to passively managed ETFs in that their goal is to track rather than beat their underlying index.

Fund managers build an index fund’s portfolio by pooling investors’ money to purchase the same assets the index contains, or a representative selection of them, to match the index’s performance. This hands-off management approach results in lower fees compared to actively managed funds. The trade-off is a relatively small selection of funds to choose from since the vast majority of mutual funds are actively traded.

You can buy a mutual fund from the company that issues it if that company is a brokerage such as Vanguard. If it’s not, or you prefer to use a different brokerage, you can buy it from any brokerage that offers it.

BlackRock, for example, has its line of mutual funds, but you can’t buy them directly from BlackRock because it’s not a brokerage. You can also buy them from Vanguard, which sells its mutual funds as well as mutual funds from BlackRock and many other companies, including rival Fidelity.

Mutual funds don’t have share prices, per se. They have net asset values or NAVs. To get the per-share NAV, the fund subtracts its liabilities from the total value of its assets, then divides that difference by the number of shares outstanding. Each day’s NAV comes out at 4 p.m., which is also the time that all of that day’s trades take place. So, if you place an order at 10 a.m., the order will be executed at 4 p.m., for whatever the NAV is at that time.

As with an ETF, your investment in an index fund is an investment in the fund itself. You don’t own the securities within the fund.

Key Differences Between ETFs and Index Funds

ETFs and index funds have many similarities, but they differ in important ways.

• ETFs trade whenever the markets are open, but mutual funds trade just once per day

• If your brokerage charges commissions on trades, you’ll pay them when you trade ETFs; that typically isn’t the case with index funds.

• Whereas ETF purchases are based on share prices, index fund purchases are based on dollar amounts.

• Many index funds have minimum investments, such as $500 or $1,000, but you can buy a single share of an ETF at its market price.

Pros and Cons of ETFs

ETFs have pros and cons you should consider before you invest.

Pros

• Can trade them when the market is open and during extended trading after-hours

• Themed funds let your target investments to industries you’re interested in

• No minimum investment — buy just one share, or even a fractional share

Cons

• If a broker charges commission, you’ll pay for each trade

• Trading on stock exchanges can be confusing

Pros and Cons of Index Funds

Index funds also have pros and cons that might influence your investment decision.

Pros

• Easy to buy

• Structured for long-term investing

• Low fees compared to actively traded mutual funds

Cons

• Trade just once per day

• Often have minimum investment

How To Choose Between ETFs and Index Funds

The differences between ETFs and index funds look relatively minor on paper, but they have a significant impact on the fund’s suitability for a particular investor.

ETFs are the better choice for investors who want the option to actively trade their investments. You can buy and sell ETF shares during market hours and in extended trading after-hours, just like you would stock shares. You also get the flexibility to buy or sell individual shares, for as little as $2 or $3 for the cheapest ETFs.

Investors who want to set and forget their investments are better off with index funds. Because they trade just once per day, for the value of a share rather than a market price, index funds are not meant for active trading. That makes them a good choice for long-term investments, and possibly even as core holdings in your portfolio.

Popular Examples of ETFs and Index Funds

Here’s a look at some popular ETFs and index funds and why they’re good for novice investors.

ETFs

• SPDR S&P 500 ETF Trust (SPY)

  • Objective: Tracks the S&P 500 index of the 500 largest U.S. companies by market capitalization

  • Price: $602.03 per share

  • Expense ratio: 0.09%

  • Why it’s good for beginners: Provides broad exposure to the overall market, but weighted toward the largest, and often most stable, companies

• Invesco QQQ Trust Series I (QQQ)

  • Objective: Tracks the Nasdaq-100 Index

  • Price: $518.11

  • Expense ratio: 0.20%

  • Why it’s good for beginners: Weighted toward tech stocks, which are typically growth-oriented, but risk is spread across 100 companies.

Mutual Funds

• Vanguard 500 Index Fund Admiral Shares (VFIAX)

  • Objective: Objective: Tracks the S&P 500 index of the 500 largest U.S. companies by market capitalization

  • NAV: $553.64

  • Minimum investment: $3,000

  • Expense ratio: 0.04%

  • Why it’s good for beginners: Provides broad exposure to the overall market, but weighted toward the largest, and often most stable, companies and has a low expense ratio

• Fidelity^® 500 Index Fund (FXAIX)

  • Objective: Tracks the S&P 500 index of the 500 largest U.S. companies by market capitalization

  • NAV: $208.29

  • Minimum investment: $0

  • Expense ratio: 0.015%

  • Why it’s good for beginners: Provides broad exposure to the overall market, weighted toward the largest, and often most stable, companies, has an ultra-low expense ratio and no minimum investment

Conclusion

ETFs and index funds both allow you to grow wealth through a single investment that provides exposure to large baskets of stocks, bonds or other assets. ETFs are the more flexible of the two and allow for active trading. But index funds’ simplicity might make them more attractive to set-and-forget investors.

ETF vs. Index Fund FAQs

• What is the main difference between ETFs and index funds?

  • The main difference is that ETFs trade like stocks, on stock exchanges, and for market prices, while index funds trade just once per day for a price that represents a fractional share of the fund’s net value.

• Which is better for beginners, ETFs or index funds?

  • Mutual funds are better for most beginners. They’re meant for long-term investing, and you don’t have to know how to navigate the stock market to buy them.

• Can I invest in both ETFs and index funds?

  • Yes. You can invest in as many of either or both as you want.

• Do ETFs or index funds cost more?

  • With hundreds of index funds to choose from, and thousands of ETFs–including both passively and actively managed funds–available, which is more expensive depends on the fund. However, ETFs generally let you invest with less money. Whereas mutual funds often have minimum investments, you can buy an ETF for the cost of a single share.

• How do I start investing in ETFs or index funds?

  • The first step is to open an account and fund an account at a brokerage. Look for a self-directed account that doesn’t charge commissions — otherwise, ETF trading could get expensive. Then research your options on the brokerage website, and select which funds to purchase. Buying a fund usually is just a matter of selecting a “Buy” button on the website or app and following the prompts to complete the transaction.

This article originally appeared on GOBankingRates.com: ETFs vs. Index Funds: A Simple Guide for New Investors