Investing

ETFs vs. index funds: What's the difference and how passive investing can help you build wealth

Anna-Louise Jackson@aljax7
Twenty/20

You don't have to actively buy and sell stocks to find success with investing. Index funds and exchange-traded funds (ETFs) make it easy for investors to cheaply and easily invest in a basket of assets.

ETFs and index funds are similar. They're both forms of passive investing and can be ideal for a buy-and-hold investing strategy. And they both offer diversification by allowing investors to buy an assortment of assets all at once rather than having to select each component individually.

But there are some key differences between these two types of investment vehicles. Here's what you need to know:

Many ETFs are index funds

An ETF can be composed of investments like stocks, bonds, and commodities, or even a combination of these assets. ETFs typically track an underlying index and are traded on stock exchanges like individual stocks, meaning many ETFs are considered index funds.

ETF providers set up a fund to track the performance of a particular index and buy the underlying assets. In turn, the provider sells shares in that fund to investors. When you buy an ETF, you own a portion of that fund — but not the underlying assets.

The world's largest ETFs track specific indexes like the S&P 500, and broader markets, like the U.S. bond market or developed and emerging-market stocks. ETFs have exploded in popularity in the past decade because they're low-cost, offer tax efficiency, and can be easily bought and sold.

However, not all ETFs are alike. Some are very niche funds that don't offer the same diversification as index funds, may charge higher-than-average fees, and could be riskier investments.

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But not all index funds are ETFs

Many ETFs today are considered index funds, but that hasn't always been the case. The first index funds were mutual funds introduced in the 1970s.

There are index funds of both the ETF and mutual fund varieties that track the same underlying index — and the differences between the two may be minimal. That's because regardless of whether an index fund is an ETF or mutual fund, the goal of each is to invest in the market itself, which is a proven strategy trumpeted by the likes of billionaire Warren Buffett.

Generally speaking, the key differences between mutual funds and ETFs are:

  • Expenses. Compared with mutual funds, ETFs typically have much lower expense ratios — which indicate the amount investors pay each year to own a fund, as a percentage of the amount invested.
  • Trading. ETFs are traded on exchanges like stocks, meaning investors can easily buy and sell them throughout the day. Meanwhile, mutual funds can only be traded at the end of the day.
  • Tax efficiency. ETFs generally offer better tax efficiency than mutual funds, because there's less turnover in the assets the funds contain. That's an advantage because any time a fund provider (ETF or mutual fund) sells an asset that has appreciated in value, it will incur capital gains — and investors are on the hook to pay taxes on those gains.
  • Investment minimums. To buy an ETF, you only need enough money to buy one share of that fund, whereas many mutual fund providers have a minimum investment of $1,000 or more.
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Why passive investing makes sense

While there may be subtle differences between index funds of either the mutual fund or ETF variety, they're outweighed by the advantages. For long-term investors, index funds of some kind are often the best way to invest.

The past decade or so has been an excellent time to invest in index funds. The S&P 500 has risen about 200% in that time frame, meaning investors could have tripled a $500 investment in the stock market.

Index funds are a popular offering in many workplace retirement plans, like a 401(k), while many investors also opt for index funds when setting up an IRA.

And experts love index funds because they're a simple, proven strategy. Index funds don't require you to be an expert: You can benefit from the market's overall gains, you won't lose money to hefty fees, and you can benefit from diversification.

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All investments involve risk, including loss of principal. The contents presented herein are provided for general investment education and informational purposes only and do not constitute an offer to sell or a solicitation to buy any specific securities or engage in any particular investment strategy. Acorns is not engaged in rendering any tax, legal, or accounting advice. Please consult with a qualified professional for this type of advice.

Any references to past performance, regarding financial markets or otherwise, do not indicate or guarantee future results. Forward-looking statements, including without limitations investment outcomes and projections, are hypothetical and educational in nature. The results of any hypothetical projections can and may differ from actual investment results had the strategies been deployed in actual securities accounts. It is not possible to invest directly in an index.

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