ETF vs index fund: what actually differs

Written by the Tactfolio research teamPublished 6 min read

An index fund is any fund that tries to match a market index, and many ETFs are index funds. So the real choice is between an index mutual fund and an index ETF. They can hold the very same stocks. The main differences are how you buy them, when the price is set, minimums and taxes in a regular account.

Key points#

  • “Index fund” describes what a fund does: it tracks an index. “ETF” describes how it trades: on an exchange.
  • An index ETF trades all day at market prices. An index mutual fund trades once a day at its closing value.
  • ETFs often pay out fewer taxable gains in a regular account. Inside an IRA or 401(k), that difference goes away.
  • Some mutual funds ask for a minimum first purchase. An ETF costs one share, or less at some brokers.
  • Neither is better for everyone. The fee and your own habits usually matter more than the label.

What is the difference between an ETF and an index fund?#

An index fund is a fund that tries to match the return of a market index, like the S&P 500. The SEC’s Investor.gov says an index fund can be a mutual fund or an ETF.

An ETF is a fund whose shares trade on a stock exchange. Many ETFs are index funds, but some are run by managers who pick what to hold. If you are new to these funds, start with what an ETF is.

So “ETF vs index fund” is a bit like asking “fruit or apple?” One can be the other. The useful question is how an index ETF and an index mutual fund differ when they follow the same index. For actively managed funds too, see ETF vs mutual fund.

Index ETF vs index mutual fund: side by side#

Index ETFIndex mutual fund
Where you buy itOn an exchange, through a brokerage accountFrom the fund company, or through a broker
When the price is setAll day, at the market priceOnce a day, at the closing net asset value
Price you payMarket price, which can sit a bit above or below the fund’s valueExactly the fund’s value per share, plus any fees
Minimum to startThe price of one share, or less if your broker sells parts of sharesSet by the fund. Some ask for a first purchase of a set dollar amount
Automatic investingDepends on the brokerUsually offered by the fund company
Yearly feeThe expense ratio, taken from fund assetsThe expense ratio, taken from fund assets
Trading costsBid-ask spread, plus any broker commissionPossible sales loads or redemption fees, depending on the fund
Taxes in a regular accountOften fewer capital gains payoutsMore likely to pay out capital gains
Taxes in an IRA or 401(k)No differenceNo difference

The net asset value, or NAV, is what all the fund’s holdings are worth per share. A mutual fund usually figures it once, at the end of each business day (Investor.gov).

How does trading differ?#

An index ETF trades during market hours at whatever price buyers and sellers agree on. An index mutual fund fills your order once, after the close.

With a mutual fund, you can place an order any time during the day. But you will not know your exact price until the fund sets its NAV that evening. With an ETF, you see the price when you trade. You also face a bid-ask spread, the small gap between what buyers offer and sellers ask.

For a long-term investor, this difference rarely matters much. It matters more if you want to trade at a set price, using a limit order.

Which is more tax efficient?#

ETFs tend to be more tax efficient in a regular, taxable account. Inside a retirement account, there is no tax difference.

When mutual fund investors sell, the fund may have to sell stocks to pay them. If those stocks rose, the fund makes a capital gain and passes it to every shareholder. You can owe tax on it even if you did not sell.

Many ETFs avoid this by swapping stocks “in kind” with big trading firms, instead of selling for cash. The SEC says ETFs therefore “typically have fewer capital gains distributions” than mutual funds (Investor.gov).

The same bulletin adds that there is no tax difference inside a 401(k) or IRA. If most of your investing happens in one of those, see IRA vs 401(k).

What about costs?#

Both kinds charge a yearly expense ratio, the fund’s costs as a share of its assets. For broad index funds, both kinds can be very cheap. What you pay depends on the fund, not on the label.

Look at three things before you choose:

  1. The expense ratio. Our guide to the ETF expense ratio shows how small gaps grow over 30 years.
  2. Any sales load, account fee or redemption fee on the mutual fund.
  3. Any commission and the usual bid-ask spread on the ETF.

FINRA’s free Fund Analyzer lets you compare the total cost of two funds over time.

A worked example#

Say you have $3,000 and want to follow the S&P 500.

  • Index ETF. At 10:30 a.m. the ETF trades at $600 a share. You buy 5 shares for $3,000. You see the price right away.
  • Index mutual fund. You place a $3,000 order at 10:30 a.m. After the market closes, the fund sets its NAV at $150. You get 20 shares. If the fund had a $5,000 minimum, you could not buy at all yet.

Both now follow the same index. If the S&P 500 rises 10% over the next year, both should rise about 10%, minus their fees.

Common mistakes#

  • Thinking an ETF and an index fund are opposites. Many ETFs are index funds.
  • Choosing by label instead of by fee. A cheap mutual fund can cost less than a pricey ETF.
  • Ignoring taxes in a regular account. Capital gains payouts from a mutual fund can create a tax bill you did not plan for.
  • Worrying about taxes inside an IRA or 401(k). There, the tax difference does not apply.
  • Trading an ETF often because you can. More trades usually means more costs.

Try it on Tactfolio#

Tactfolio strategies hold US-listed ETFs and stocks, not mutual funds. If you want to see how an index-based mix has behaved, open the 60/40 portfolio. It holds an S&P 500 ETF and a Treasury bond ETF. You can read the rules, see its hypothetical backtest and its worst years, and copy it to change the mix.

Common questions#

Is an index fund an ETF?#

It can be. An index fund is any fund that tracks an index. That fund can be built as a mutual fund or as an ETF, and many of the largest ETFs are index funds.

Is an ETF or index fund better for beginners?#

Neither wins for everyone. An ETF suits people who already have a brokerage account and want a low starting amount. An index mutual fund suits people who want to invest a fixed dollar amount on a schedule. Compare the fees first.

Are ETFs cheaper than index funds?#

Not always. Broad index ETFs and broad index mutual funds can both charge very low expense ratios. Check each fund’s fee, plus any loads, account fees or commissions.

Can I hold index ETFs in a Roth IRA?#

Yes, most brokers let you hold ETFs and index mutual funds in an IRA, including a Roth IRA. Inside the account, the tax edge of ETFs does not apply. Your choice can come down to fees and convenience.

Why does an ETF price differ from its NAV?#

An ETF trades on an exchange, so its price moves with supply and demand during the day. Big trading firms can swap shares with the fund, and that keeps the price close to the NAV. Small gaps are called premiums or discounts.

Sources

Put it into practice