Understanding Index Funds and ETFs
What these two common pooled funds are, and how they differ in practice.
Index funds and exchange-traded funds — ETFs for short — are two of the most widely used pooled investment products around. They have a lot in common, which is exactly why the differences between them are worth understanding. This article covers what each one is and where they part ways. It's educational reference material, not investment advice.
What an index is
A market index measures the performance of a defined group of assets — maybe a broad selection of large companies, a particular industry, or a category of bonds. The thing to know is that you can't actually buy an index; it's just a benchmark that stands in for how that group of assets is doing. Index funds and many ETFs are built to track the performance of a specific index.
Index funds
An index fund is a kind of mutual fund that aims to match a particular index by holding the same assets — or a representative sample of them — in similar proportions. Since it just follows a predefined index rather than betting on hand-picked investments, it's called passively managed, and passive funds usually charge lower management fees than actively managed ones. Mutual fund shares are bought and sold at a price worked out once a day, after the market closes.
Exchange-traded funds
An ETF also holds a collection of assets, but it trades on a stock exchange. Many ETFs track an index and are passively managed too, though actively managed ones exist as well. The key difference from a mutual fund is that ETF shares change hands throughout the trading day at market prices, much like individual stocks. So an ETF's price moves around during the day instead of being set just once after the close.
Common differences
Both share the same goal: diversified exposure to a group of assets, often at a fairly low cost. Where they part ways is mostly in how they trade and a few structural details. ETFs trade during market hours and may ask for no minimum beyond the price of a single share, while index mutual funds trade once a day and sometimes set minimum investment amounts. The two can also be treated differently for tax purposes, which may matter in a taxable account.
Considerations
When sizing up either type, investors tend to look at the expense ratio — the annual fee, expressed as a percentage of the amount invested — along with which index the fund tracks and how closely it has actually stayed with it. And as with any investment, these carry risk: their value can rise or fall, and past performance doesn't guarantee future results.
Summary
So, in a nutshell: index funds and ETFs are pooled products that often track a market index to deliver diversified exposure at relatively low cost. Index funds are mutual funds priced once a day; ETFs trade throughout the day on an exchange. Which one fits comes down to your own preferences and circumstances.