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Index funds and ETFs can be a fundamental part of building a successful portfolio. What you need to know

September 28, 2022, 8:00 AM UTC
An illustration showing a comparison of ETFs and index funds
Index funds can be traded only at the end of the day, while ETFs can be traded throughout the day.
Illustration by Tim Boelaars

There are many assets to choose from when building an investment portfolio.

Index funds and exchange-traded funds (ETFs) are two examples of common assets that offer low-cost ways to simplify and diversify your portfolio by packaging several stocks (and in some cases bonds) into one investment.

If you’re trying to decide which is best for you, here are some key considerations.  

Index funds vs. ETFs 

An index fund is a type of mutual fund that’s designed to track or match the performance of a benchmark index—which is a collection of securities used as a standard against which the performance of other securities, asset managers, or investment strategies can be measured.

One example of a popular benchmark index is the S&P 500, which essentially tracks the largest 500 companies in the U.S.   

An ETF is an asset that packages a mix of securities such as stocks or bonds with the goal of tracking a specific index—like the previously mentioned S&P 500. ETFs differ from index funds in that ETFs can be actively managed. These actively managed ETFs rely on a fund manager or team to select and package the underlying assets that make up the ETFs—to later sell to investors.

Below, we will dig into the specifics for each investment.  

What is an index fund? 

Index funds give investors the ability to invest in broad segments of the market by tracking their performance. The chosen index may track large companies like the Dow Jones Industrial Average (DJIA) or track one sector of the market like the Nasdaq composite, which is primarily made up of technology companies. An index fund can even track bonds like the S&P Aggregate Bond Index.  

Index funds are important because their returns are hard to beat over time. In fact, both fund managers and individual investors often fail to beat an index fund that tracks the S&P 500. Instead of researching and choosing an individual stock, index funds offer the ability to achieve instant diversification and lower your overall risk compared to owning a single stock.  

How index funds work 

Index funds work by accumulating money from investors to buy the assets of the benchmark the fund is tracking. A fund like the Vanguard Total Stock Market Index Fund (VTSAX) owns a portion of more than 4,000 different publicly traded companies. This is much more efficient than an individual investor attempting to buy hundreds or even thousands of stocks on their own. Index funds are passively managed because the underlying index typically does not undergo significant changes from year to year.  

Pros and cons of index funds 

The upsides of investing in index funds have been well documented and are often a cornerstone in financial self-help books, retirement plan options, and financial planners’ recommendations. This is because on performance, diversification, and cost, index funds are difficult to beat.  

This does not mean that index funds are without weaknesses. “Other important differences include investment minimums,” says Rodney Comegys, the global head of the Equity Index Group at Vanguard. Depending on the provider of the index fund, there may be a minimum investment required, which could range between $1,000 to $3,000.  

This is generally not the case with ETFs, regardless of whether that ETF tracks an index or not. These minimums can delay an investing decision and cause investors to lose out on the potential gains and compounding interest in the meantime.  

Another disadvantage is the way capital gains are treated with index funds. There are two ways an investor could be taxed on capital gains. The first is when you sell your portion of the fund for a price higher than you paid, which is a move that you can control.  

The second way that you could pay capital gains tax is when the fund itself sells one or more of its holdings in the fund. Should this occur, the capital gains taxes may be passed to investors, and it is not in their control.  

What is an ETF? 

An ETF is a basket of investments like stocks or bonds. “They allow you to invest in lots of securities all at once rather than needing to pick each individual security on your own. Think of it like grocery shopping,” says Kyle McBrien, a CFP at Betterment. “If you walk through the entire store picking all your own food, you may pick some healthy choices, and you may choose some unhealthy choices. Over time, it can be difficult to consistently create a balanced diet,” he continues.  

Using McBrien’s metaphor, investing in an ETF is like having a professional do all the shopping for you.  

How ETFs work 

Like index funds, ETFs also function by pooling money from investors to buy assets. ETFs will typically track a specific index, making them nearly equal to index mutual funds—but there are a few key differences in how an ETF operates.  

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. ETFs that are actively managed are made up of assets chosen by the fund manager, who creates and puts together the ETF and may adjust which stocks it buys and holds based on the market. Keep in mind that actively managed ETFs may come with higher fees. 

Pros and cons of ETFs 

Many of the advantages for index funds also apply to ETFs. But there are a few places that make ETFs stand out from their index fund counterparts. Capital gains for ETFs are treated the same as stocks, so if you sell an ETF for a gain then you may be subject to capital gains tax.

The ability for intraday trading can also be an advantage if you’re looking to be more active in your investment strategy. For more advanced investors, ETFs can also be traded with options as well as short-sold. 

Sometimes that flexibility can be a disadvantage, depending on the investor. “From a behavioral standpoint, giving someone more flexibility to trade throughout the day may cause paralysis by analysis, when in reality, a long-term investor generally shouldn’t be concerned about intraday price movements,” says McBrien. 

How to choose between index funds and ETFs 

Index funds and ETFs share many important traits. “Both can offer low-cost, broadly diversified exposure to the stock and bond markets. And both operate under the same regulatory structure, and therefore offer the same investor protections,” says Comegys.  

In many cases, investment firms may offer a particular fund that tracks the same index. One example is the Vanguard 500 Index Fund that is available under the ticker symbol VOO, which is an ETF, but there is a mutual fund version under ticker symbol VFIAX.  

In the end it comes down to a matter of preference, how sensitive you are to fees, and what options are available at your brokerage of choice.  

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