Index Funds and ETFs Explained: How They Work and What to Compare
Index funds track a market index instead of picking investments. ETFs and mutual funds are two ways to hold them. Here is how they work, what they cost, and the differences that actually matter.
An index fund holds the securities in a market index, such as a broad stock market index, in roughly the same proportions. It doesn't try to pick winners. Its goal is to match the index's return, minus costs. Index funds come in two main wrappers: mutual funds and exchange-traded funds (ETFs).
The short version
- Index funds aim to track an index, offering broad diversification at low cost.
- Costs matter: index funds often have much lower expense ratios than actively managed funds.
- ETFs trade on an exchange throughout the day; mutual funds are bought and sold at the end-of-day price.
- ETFs are often more tax-efficient in taxable accounts, though many index mutual funds are also efficient.
- Compare what index a fund tracks, its costs, tracking difference, and how you'll buy it.
What an index is
An index is a list of securities with a rule for weighting them, such as by company size. Indexes cover broad markets, specific sectors, countries, bond markets, and many other segments.
Mutual fund vs. ETF
| Index mutual fund | Index ETF | |
|---|---|---|
| How you buy | Through the fund company or a brokerage | On an exchange, like a stock |
| Price | Once a day, at net asset value | Throughout the trading day |
| Minimum investment | Sometimes required | Price of one share, or less with fractional shares |
| Automatic investing | Usually easy | Depends on the brokerage |
| Tax efficiency in taxable accounts | Often good | Often very good, due to how shares are created and redeemed |
| Trading costs | Usually none at the fund company | Possible bid-ask spread |
Why cost matters so much
A hypothetical $100,000 invested for 25 years at a 7% gross return:
Show the numbers behind this chart
| Ending value | |
|---|---|
| 0.04% expense ratio | $537,694 |
| 0.75% expense ratio | $455,222 |
See what a 1% fee really costs and expense ratios explained.
What to compare between index funds
- The index: Two "total market" or "large company" funds may track different indexes with different holdings.
- Expense ratio: The annual cost.
- Tracking difference: How closely the fund's actual return matches the index after costs.
- Size and trading volume for ETFs, which affect bid-ask spreads.
- Tax efficiency if you hold it in a taxable account.
- Account availability: Your workplace plan may only offer certain funds.
Index investing's limits
- You get the market's return, including its declines. Index funds aren't protected from losses.
- Some indexes are concentrated in a small number of large companies or sectors.
- Narrow or exotic indexes can carry more risk and higher costs than broad ones.
Diversifying across asset classes still matters; see asset allocation and rebalancing.
The takeaway
Index funds offer broad diversification at low cost by tracking a market index. ETFs and mutual funds are two ways to hold them, with differences in trading, minimums, and tax efficiency. Compare the index, the costs, and how closely the fund tracks it.
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