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Over 50% of Americans now own stock, which is a big jump up from 50 years ago. ETFs and index funds make investing more accessible to the average person than ever before.
But what are these things exactly, and how can you use them?
When you start investing, you need to understand the difference between ETF and index fund investing. Here’s exactly what each of them is, why it matters, and how you can start investing today.
Index Fund vs ETF: Here’s What’s Similiar
ETF stands for exchange-traded fund. Index funds and ETFs are very similar except for a few key differences which we’ll get into in a minute.
They both work to match a predefined segment of the market. This could be large companies, small companies, or tech companies. Alternatively, it could be a stock market index like the S&P 500 or the Dow Jones Industrial Average (DJIA).
Why does that matter? When you buy an individual stock, your money grows or declines with the success of the company.
Very few investors are good at actually picking out specific stocks in companies that will be successful down the line. Warren Buffet has succeeded at this, but he dedicated his life to it and typically buys either the whole company or a large stock position in it. This gives him control of the company, which is something the average investor can’t achieve.
In contrast, both Exchange Traded Funds (ETFs) and Index Funds can be thought of as containing a “basket” of stocks.
The idea is that some companies tracked by the index will stay steady, some will flop, and some will prove to be huge successes. Hopefully, the successes will outweigh the flops.
Historically, that’s been proven to be true. The historical stock market return on average is 10%, which is pretty respectable, considering you’re lucky to get 1-2% in a high yield rate savings account.
They Both Work Towards the Same Goal
Index funds and ETFs both have the same goal—long term financial success achieved by having the price of the index fund or ETF go up in value. Of course, in recessionary periods like we’re in now, this may not occur.
Whether you invest in an ETF or index fund, ideally you want to hold them as long as possible, though you can sell them if you need to.
ETFs and index funds are not overnight get-rich-quick tools. They’re designed to help you grow your money over a long period of time, weathering all the ups and downs in the market.
Biggest Differences of ETFs vs. Index Funds
ETFs and index funds serve the same purpose, but there are a few things to consider:
ETFs trade throughout the day like stocks, but index funds can only be bought and sold at the end of the day after markets are closed.
This makes ETFs more fluid and easier to get in and out of than index funds. But if you’re holding an investment for 20 years, whether you sell at noon or 5 is likely to have little difference.
If you buy and sell commission-free, ETFs are usually cheaper than index funds.
Index funds often have a high minimum investment amount.
Vanguard has a minimum investment of $3,000 and T. Rowe Price has a minimum of $2,500. These minimum balances can make it harder for the average person to invest in index funds.
Generally, investors who buy an index fund do so through a mutual fund designed to mimic the index. This means the index fund is professionally managed. With ETFs, they are also professionally managed, but usually by SEC-registered investment advisers.
ETFs are more tax-efficient than index funds.
You own an ETF, so when you sell it, any capital gains taxes (that is, taxes on the profit) are your responsibility. Since index funds are structured differently, you may have a tax responsibility, even if you don’t sell your shares.
When you sell in an index fund, it goes to the fund manager, who sells securities to get the money for you. When there’s a profit, the gain is passed on to every investor, including the tax responsibility for that gain.
How Can I Invest in an ETF or Index Fund?
To invest in an ETF or index fund, you’ll need a brokerage account with a broker where you can buy and sell securities. Compare fees, minimum account balances, and other expenses associated with different brokers. Doing so will help you pick the best place to invest.
If you don’t know where to start, the Robinhood app is a great way to get started.
In addition to giving you commission-free trades, it will let you manage your ETF or index fund “buy / sell” orders right from your smartphone.
When you want to invest, it’s easy to get caught up trying to find the best vehicle for your investments. But chances are, you’ll realize years have passed and you haven’t invested a dime.
It’s more important you start investing today. You can always pull your funds and transfer them to a new account in the future, and learn from your financial mistakes along the way. That’s how you learn best.
Once you start investing, keep it up! It’s thrilling and rewarding to watch your money grow. To keep investing more, watch out for lifestyle inflation. Whenever you get a bonus or promotion, invest that money and keep all of your other expenses the same.
The other way you can have more money to invest is by cutting back on expenses. There are plenty of things you can save money on, and each little bit helps when you’re looking at a good ROI over the next 20 years.
The Difference Between ETF & Index Fund Investing
Understanding the difference between ETF and index fund is a useful part of your investing knowledge.
When in doubt, simply know that the ETFs are more flexible to buy and sell, tend to have tax advantages and have lower entry thresholds.
However, for long-term investors ETFs and index funds that track the same index (like the S&P 500 or DJIA) tend to provide extremely similar returns.
In summary, the biggest differences between an ETF and an Index Fund are:
- ETFs trade throughout the day, but index funds are only bought or sold after the market closes
- Index funds usually have a high minimum investment amount
- ETFs are usually cheaper (lower management costs), when bought commission-free
- ETFs are typically more tax-efficient than index funds
If you want to invest in the stock market, they’re both practical tools for long term investing. Don’t let the minor differences between the two hold you up. Start today, and hold on to your assets as long as you can.
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