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Comparing Index Funds and ETFs: What You Need to Know

When investing, I strongly encourage you to invest to approximate, not try to beat, the market. This means investing in a manner the mirrors the overall stock or bond market. But, there are actually two different ways to do this: you can use index funds and ETFs.

index funds and ETFs

So, which way is better? Or does it not matter?

Let’s explore this question a bit in this post…

The right way to invest

This is a refresher but it’s such an important concept that I always reiterate when I can.

Investing in individual stocks or trying to time the market is speculation, not investing. By investing in the long term in a manner that approximates the market, you are investing in the overall national/global economy and ingenuity of humankind.

This has been a safe bet throughout the history of the stock market. If you put money in the overall stock market at any point in history and left it there for 20 years, you would have made a lot of money.

In fact, by managing your portfolio this way (passively), statistics show that you have a portfolio that is better than 80% of people in any given year who try to actively “beat the market.”

This is a big part of the simple habits to make you financially successful and taking the 10 steps to reach financial freedom!

But again, you can accomplish investing in the overall market with both index funds and Exchange Traded Funds (ETFs).

Index funds and ETFs

Let’s get into some basics…

Index funds

An index is a collection of stocks that it thought to give a good average or overall view of the entire or a specific part of the market.

For example, the S&P 500 is a stock index composed of 500 stocks thought to give a good overall view of the entire U.S. stock market.

And index fund is a mutual fund the mirrors a specific index. So an S&P 500 index fund mirrors the S&P 500 index.

By investing in grandly diversified low cost index funds, you can passively invest in and approximate the overall market.

ETFs

Exchange traded funds are baskets of assets, like stocks. This may seem like all semantics compared to what an index fund is. And guess what? It is! All of finance is pretty much semantics and arbitrary human created constructs. But, regardless of this, we all play by the same rules and therefore it makes sense to try and know them.

The main difference

Anyway, the main difference between index funds and ETFs is that ETFs trade like regular stocks, on the open market.

This means that you can buy or sell an ETF at any point that the stock market is open. The price of the ETF is constantly re-valuated and can be sold at any moment for its current value. In this sense, ETFs are more liquid than index funds.

In contrast, index funds are priced only at the end of the market’s day. And that is the only time and price they can be bought or sold for.

What are the associated costs of index funds and ETFs?

Both index funds and ETFs have associated benefits and downsides when it comes to costs.

Index funds typically don’t have shareholder transaction costs. So when you trade them, the associated transaction fees are minimal or none.

However, ETFs in general have lower management and tax fees.

So, when it comes to cost, you have to look at your individual options and see what the associated expense ratios are. In some cases, index funds will be less. In others, ETFs will be less. It will depend on the brokerage, fund/ETF, and other factors.

So, which is better?

Honestly, both are great. So long as they mirror a broad and diverse (ideally the overall) market, both index funds and ETFs are fantastic investing options.

Over the long term, both index funds and ETFs have performed similarly when the indexes mirrored are controlled for.

Similarly, neither are safer than the other as it depends on the stocks in the funds.

What do I do?

Honestly, whether a fund that I am buying is an index fund or ETF does not enter into my decision-making.

I look for either an index fund or ETF that mirrors the market that I want to approximate…like the total U.S. stock market.

If only one of the other is available in the brokerage I am looking at, like in my 403b, then I use that one. If both are available, I look for the lowest expense ratio and choose that one.

Currently, all of my investments are in index funds. For the exact reasons I list above, not some concerted effort to only use index funds rather than ETFs.

The bottom line

I see a lot of people asking and comments responding online about which is better, index funds or ETFs.

For me, this is a wasted argument. And it’s probably being had by people who just really like getting into the weeds of this stuff. Which I admit that I sometimes do.

But, for the overwhelming majority of investors, it really just does not matter. When properly selected, both do a great job at allowing you to invest passively in the overall market according to your asset allocation.

That way you can sit back, enjoy life, and know that your investments are helping you reach financial freedom according to your written financial plan! (Reminder, you can see my actual written financial plan here.)

Here are the 3 posts that I consider required reading for anyone that wants to learn more about investing in the stock market:

You can also register for my free masterclass webinar on the 12 Steps to Financial Freedom here!

What do you think? Do you prefer index funds? Or ETFs? Do you think there is a big difference? Let me know in the comments below!

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    Jordan Frey MD, a plastic surgeon in Buffalo, NY, is one of the fastest-growing physician finance bloggers in the world. See how he went from financially clueless to increasing his net worth by $1M in 1 year and how you can do the same! Feel free to send Jordan a message at [email protected]

    4 thoughts on “Comparing Index Funds and ETFs: What You Need to Know”

    1. I think this would be a confusing post if I was early to investing. An index fund is the term given to a broad collection of stocks. And index fund can be purchased as either a mutual fund or as an ETF. I think you are trying to say that you purchase your index funds as a passively managed mutual funds. Many people prefer to purchase their index funds as ETFs (e.g. SPY, IVV) for the liquidity that you mention (sold like a stock…don’t have to wait till the end of the day to sell) but also because of the tax efficiency they provide (…when held in a brokerage account you only pay taxes on quarterly dividends from the ETF index fund, but if you hold a mutual fund index fund in a brokerage account it will distribute capital gains (as well as quarterly dividends) at the end of the year from stocks that were sold to rebalance within the fund…thus triggering a taxable event).

      As you mention Buying the cheapest index fund available in a tax deferred account (401k/403b) makes sense and this will 99% of the time be a mutual fund index fund. But If held in a taxable account (eg a brokerage account) then holding an index fund ETF makes the most sense to minimize taxable events out of one’s control.

      Reply
        • Ha! speaking of semantics 🙂 great post as always Jordan but yes I agree with Mack above.

          BTW, diving into the weeds I was saddened how Vanguards TDF’s gave off huge cap gains to investors, but doesn’t Vanguard mutual funds use ETF’s as a share class, and theoretically should not have had huge cap gains?

          Reply
          • Yeah that was disappointing about Vanguard target date funds. Thankfully I hold my only Vanguard TDF in a tax advantaged account but that is just luck.

            My understanding is that they needed to sell their TDF fund holdings and then re purchase in a new holding because they lowered the minimum “buy in” for a class of the TDF which allowed many more 401ks etc to join. This sell off triggered the capital gains. Seems like a logistical thing that was maybe not thought well out from the start.

            I don’t think it means no one should hold a TDF in a taxable account but does give some pause if it can be avoided.

            Reply

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