18 Jun Index funds and ETFs: What’s the difference?

Q. What’s the difference between an index fund and an exchange-traded fund? How do I know which is better for me?
— New investor

A. We’re glad you’re asking rather than invest in something you don’t understand.

An index fund is a type of mutual fund, while an exchange-traded fund, or ETF, is a different kind of basket of securities.

Both ETFs and mutual funds collect investor money and buy securities, which are then managed according to the fund’s goal, said Jim McCarthy, a certified financial planner with Directional Wealth Management in Rockaway.

He said these investment products may seem similar, but there are important differences to understand.

First, ETFs trade like stocks and can be bought or sold throughout the trading day, while mutual funds settle after the market closes.

Then there’s the cost to you.

“One of the biggest differences is the investment minimums required in order to invest in the product, and a mutual fund usually has a higher investment minimum as compared to an ETF,” McCarthy said. “Expense ratios should also be considered because expenses can be a drag on performance in the long run.”

Another key difference is the taxation of each product.

He said mutual funds usually have a higher tax consequence compared to an ETF.

“This is important because it may make sense to pick an ETF or a mutual fund depending on the type of account that the fund will be held,” he said.

Another difference is that you can make automatic investments into a mutual fund but you cannot with an ETF, he said.

Now, to indexing.

Index-style funds can be found in both mutual funds and ETFs.

“Indexing is a type of investment strategy which is also known as passive investing,” McCarthy said. “An index fund tracks a certain index such as the S&P 500, Russell 2000, Dow Jones or Nasdaq just to name a few.”

He said indexing is considered passive investing because it tries to replicate the stocks in a given index.

“Indexes usually don’t swap stocks in and out that often, therefore there isn’t a direct management influence in the fund,” he said. “This passiveness is what makes them more tax efficient as well as less expensive than actively-managed funds.”

McCarthy said both mutual funds and ETFs provide a simple way for you to invest your money, and index investing can capture a wide exposure to the market.

“If you are going to invest in an index-style fund, then expenses are relatively low on both mutual funds and ETFs,” he said. “Are you going to invest regularly in the fund or is it a one-time investment? Are you worried about taxes? Both of these products can meet your investment goals – it just depends on what your goals are.”

Consider speaking to a financial advisor who knows more about your specific situation before making your decision.

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This story was originally published on June 18, 2019.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.