ETF vs. Index Fund: Which Is Right for You?

ETFs (exchange-traded funds) and index funds are two very popular types of investment. They are well known for the diversification they can bring to a portfolio, and appeal especially to investors who want to take a more passive approach to managing their assets.

Despite having a lot in common, the way ETFs and index funds work, their tax efficiency, and their flexibility all differ in important ways.

If you are considering these two investment options but need a little help deciding between them, keep reading.

What is an ETF?

Definition and how it works

An exchange-traded fund (ETF) is an investment fund that can be compared to a basket of different assets (stocks, bonds, or commodities, etc.). Just like any other stock, it is traded on a stock exchange, allowing investors to buy and sell it throughout the day at market prices. ETFs are designed to track the performance of an index (e.g. S&P 500), sector, or asset class — a good option for those who seek diversification and liquidity.

Pros and cons

Pros of ETFs

• More control: If you’re a sophisticated investor, you can use all your advanced trading methods, like stop-loss orders and margin trading.

• Tax optimization: ETFs will trigger fewer taxable events due to their “in-kind” process, which means they don’t generate capital gains when selling their shares.

• Smaller investment barrier: small-scale investors can start with as little as the cost of a single share, with no need to invest large amounts of money initially.

Cons of ETFs

• More stress: With more freedom comes more responsibility. Price fluctuations and market volatility can create some anxiety.

• Trading commissions: Depending on your broker (the company that manages your transactions), you might encounter more fees for each exchange.

• Complexity and temptation: Beginners can become overwhelmed by the many options and also suffer from the intraday temptation to sell and buy constantly.

Example: Vanguard S&P 500 ETF (VOO)

Vanguard S&P 500 ETF (VOO) invests in stocks in the S&P 500 Index, which represents 500 of the largest U.S. companies. The aim is to closely track the index’s returns. The expense ratio (as of 04/26/2024) is 0.03%. To invest in this index fund, you’ll need to buy 1 share minimum.

What is an index fund?

Definition and how it works

An index fund is a type of mutual fund that is passively managed and tries to replicate the performance of an important index of the market, like the S&P 500 or Nasdaq 100.

ETFs are similar to index funds in that they, too, are usually managed in a more passive way, and, like index funds, they also try to follow an index. But one big difference between the two is that, unlike index funds, exchange-traded funds are traded on the market like stocks.

That distinction is key to understanding how index funds and ETFs operate on the market.

Pros and cons

Pros of index funds

• Simplicity: Index funds are easier to understand and can be a perfect way for new investors to test the waters.

• Automation: With index funds it’s possible to keep reinvesting your dividends automatically, taking advantage of the compound effect with less effort.

• Predictability: Since they try to replicate a benchmark index, index funds are somewhat predictable and often perform better than actively managed funds.

With advantages like that, it’s no surprise that according to Investopedia, in 2023 index funds had grown to comprise about half of all U.S. fund assets.

Cons of index funds

• Less flexibility: Index funds might not be the right choice for investors who want to respond fast to the changes of the market.

• Less tax efficiency: With the capital gains created by the transactions inside the fund, you’ll likely encounter more tax events, especially in taxable accounts.

• More investment upfront: It’s not uncommon for index funds to have higher minimum investments, like $1 000 or similar prices.

Example: Schwab S&P 500 Index Fund (SWPPX)

Schwab S&P 500 Index Fund (SWPPX) is a fund with no investment minimum. It aims to track the total return of the S&P 500 index. The expense ratio is 0.02%.

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Key Differences: ETF vs Index Fund

Liquidity and trading

Since, as their name suggests, ETFs are traded like stocks, you can buy and sell them anytime during the business hours of the stock market. Because of that, they have more liquidity, but they also experience price fluctuations throughout the day.

In contrast, index funds can only be negotiated at the end of each trading day. Their price is set based on the fund’s net asset value (NAV).

Cost structure

Another important factor is the costs. ETFs usually have fewer expenses compared to index funds, but they can charge brokerage commissions and bid-ask spreads. Those fees might not look bad at first, but they can add up if you buy and sell often.

Index funds, on the contrary, have higher management fees, but they offer a nice feature: you can keep reinvesting your dividends automatically, without paying extra fees every time you invest. This can be a huge plus if you prefer a more hands-off investment approach.

Tax efficiency

Taxes are a major factor to consider when building your portfolio and choosing your assets

ETFs are well known for their tax efficiency. This is primarily due to their famous “in-kind” method. Simply put, when an investor wants to sell their ETF shares, the fund doesn’t need to make any cash; those shares can just be exchanged for other underlying assets.

How does that work?

Index funds do the opposite: they create more taxable events because they usually generate more capital gains with their transactions.

Dividend reinvestment

When it comes to saving money, compound interest is an investor’s friend. Instead of receiving cash payouts, you can reinvest your dividends and buy more shares of an ETF or index fund. Many brokers and fund providers offer an option to automatically reinvest dividends into additional shares.

Flexibility and accessibility

Another key difference is related to flexibility. Since ETFs are traded throughout the day like stocks, experienced investors might prefer them, as they can apply advanced trading techniques and keep a close eye on the market. Contrarily, index funds might be a better choice for investors who do not want the stress of daily trading and prefer a more set-it-and-forget-it style.

Lastly, ETFs can be an excellent option for those who want to focus on specific industries, trends, or sectors. Index funds are more conservative and don’t usually go much further than their broad market indices like the S&P 500.

ETFs vs. index funds: major similarities

Despite their differences, index funds and ETFs have much in common. That’s why they are usually paired together when considering portfolio diversification options.

They both offer a somewhat passive strategy, helping new investors navigate uncharted waters with a low barrier to entry. Because they try to mimic the performance of a chosen index instead of outperforming it, the costs (and stress) are kept low.

They are also hugely popular. According to J.P. Morgan, the global ETF market is worth $13 trillion. And according to Bankrate, all seven of the world’s largest mutual funds are index funds.

One great advantage of both is the diversity they bring to the table. With just one single purchase, you can benefit from multiple assets across many industries and sectors. You get all that diversity without having to choose and analyze each asset, which makes them even more accessible to individuals who don’t yet know all the ins and outs of the enormous world of investing.

This chart made by Schwab shows how diversification can be crucial to spreading out risk and reducing the chance of losses:

Index funds and ETFs are especially great for people who are in it for the long run and want to maximize the compounding factor of their money over a long time. Retirement accounts are a perfect example of this.

Last but not least, transparency is a huge bonus of both of these investment types. They both disclose their holdings frequently, but especially ETFs. This way, investors can have more peace of mind knowing exactly what they own and what’s happening with their wealth.

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Comparison table: ETF vs index fund

The table below juxtaposes the significant factors an investor should consider and how they differ between an ETF and an index fund.

While ETFs and index funds have some significant advantages, your choice of instrument will ultimately depend on what you prioritize in your investment journey and what’s more important to your specific financial goals, especially in the long term.

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ETFs vs. index funds: tax implications

ETFs and index funds are both considered tax-conscious investments. Still some investors may like to know more about the specific details, especially those who are in a higher tax bracket.

When it comes to fewer takes, ETFs win the race. This is largely because of their “in-kind” redemption process, where the fund doesn’t need to sell assets to compensate for the sold shares. Instead, authorized participants can exchange those shares for other securities (not cash). That way the creation of capital gains and taxable events are reduced.

Still a little confused? Check out this explanation below:

The strategy

Let’s say an ETF fund gets a lot of redemptions due to a bad day at the market. What happens then is that those investors don’t get cash for their shares, they get some other assets owned by the fund, such as stocks or bonds.

The benefit

Because the fund doesn’t actually sell anything, these kinds of transactions don’t trigger taxable events like selling assets for cash would. That’s why tax-conscious investors often choose ETFs.

Index funds are technically tax-efficient, but they are not as good in that aspect as ETFs. They do have to generate cash when investors cash out, and if those transactions generate capital gains, they get distributed to all investors in the fund. And then, of course, those distributions get taxed. That means you’ll possibly deal with more taxable events, even if you didn’t sell anything yourself.

Both investments are good when it comes to tax management, but you have to consider those details and how they impact you and your portfolio strategy.

How much can I make in 10 years? An ETF vs an index fund

Let’s compare profits from an ETF (SPDR S&P 500 ETF (SPY)) and an index fund (Vanguard 500 Index Fund (VFIAX)) over 10 years with an initial investment of $10 000, including fees and taxes. We’ll assume:

• 8% annual returns (the historical S&P 500 average);

• 1.5% yield reinvested every year;

• 15% long-term capital gains tax;

• 15% qualified dividends tax;

• 22% non-qualified dividends tax.

Step 1: Profit before taxes and fees

Both an index fund and an ETF will earn $21 589 before taxes and fees, according to the formula A=P(1+r)t.

Step 2: The fees

To calculate the impact of fees, use this formula, where A1 is the profit from the SPY ETF (0.09% expense ratio) and A2 — profit from the VFIAX index fund (0.04% expense ratio).

A=(1.08 - expense ratio)10

A1 = $21 421

A2  = $21 520

Step 3: The dividends

The total dividend income in both cases is $1 605, according to the formula:

Adiv= P×(1.015)10

The ETF (SPY) is more tax-efficient: 80% of the dividends are qualified (taxed at 15%), 20% are non-qualified (taxed at 22%). The index fund (VFIAX) is less tax-efficient — it has 70% of qualified dividends and 30% of non-qualified dividends.

The table below breaks down the dividend tax.

Dividends after tax:

• SPY ETF: $1 605 - $250 = $1 355

• VFIAX index fund: $1 605 - $300 = $1 305

Step 4: Capital gain and tax

Capital gain = final value − initial investment 

Tax = capital gain × 15%

All in all, the index fund slightly outperforms the ETF due to its lower expense ratio.

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Which one should you choose?

Both ETFs and index funds can help you achieve your long-term goals and increase your wealth. However, there are some factors to consider before committing to either of them.

Best for long-term investors

Do you have a focus on long-term investments, especially with retirement accounts? If yes, index funds could be the best option. You don’t have to trade manually and there’s no bid-ask spread. Unlike ETFs, you buy or sell at the net asset value (NAV), avoiding price fluctuations during the day.

Best for active traders

If you see yourself trading often, maybe ETFs are a better option for you. Buy and sell with lower trading costs anytime throughout the day and use advanced trading techniques like stop-loss and limit orders.

Best for tax efficiency

Are you extra worried about your tax losses? If yes, remember that ETFs offer more tax efficiency. They are structured to avoid capital gains distributions thanks to their in-kind redemption mechanism.

Risk tolerance considerations

Choose an ETF or an index fund based on your risk tolerance. Low-risk investors might prefer index funds to avoid market timing temptations, plus there’s no need to worry about bid-ask spreads. ETFs usually attract investors who are more open to taking risks, as there’s more control over buying and selling and you can use advanced trading strategies.

FAQ

Are ETFs safer than index funds?

Both ETFs and index funds track underlying assets, meaning their risk level depends on the securities they hold, so it would be incorrect to say that one is “safer” than the other. However, some key differences exist.

• ETFs trade like stocks, meaning prices fluctuate throughout the day, while index funds settle at the day's NAV. This can lead to price discrepancies in volatile markets.

• ETFs are more flexible — they can be bought or sold anytime during market hours — while index funds only trade at the end of the day.

• ETFs are generally more tax-efficient due to their in-kind redemption mechanism.

Are ETFs better than index funds for beginners?

Beginners will probably like the simplicity of index funds, whereas experienced investors might enjoy the flexibility of ETFs more.

How does tax efficiency impact my investment?

Tax efficiency is about how much of your returns are lost to taxes. In general, ETFs are more tax-efficient than index funds due to their in-kind redemption mechanism. If you are planning to invest in a taxable brokerage account, an ETF might be a better option for you. However, if you are investing in a tax-advantaged account (IRA, 401k), both ETFs and index funds work — tax efficiency doesn’t matter.

Which is better for long-term investing: ETFs or index funds?

Both can be optimal choices, but consider these factors:

ETFs usually have lower expense ratios, but you may have to pay brokerage commissions.

As we mentioned, ETFs tend to be more tax-efficient due to their structure.

Index funds may be better for investors making regular contributions.

If you are a long-term investor who doesn't need intraday trading, index funds may be a simpler option (for active traders, on the other hand, ETFs may offer more flexibility).

Do ETFs pay dividends?

Just like individual stocks and index funds, ETFs pay dividends. ETFs collect them from the stocks and pay them to investors monthly, quarterly, or annually (depending on the conditions). The good news is, you can automatically reinvest the dividends using dividend reinvestment plans (DRIPs). Note that ETF dividends are subject to taxes.

Final thoughts

ETFs and index funds are both fantastic options that could work for many types of investors with different needs. As is usually the case with investing, there’s no right or wrong answer, but you do have to be mindful of what kind of investor you are and what your long-term financial goals are.

Both ETFs and index funds give you the chance to add more diversity to your portfolio and lean in on a more passive approach, without the stress of having to purchase each asset on its own. Remember these options on your investment journey, and consider FBS for all your trading needs.