ETFs vs Index Funds

The respective structures of index funds and ETFs overlap in a few areas, but those structures do display at least four key differences:

1. Investment Fees and Expenses. Index funds typically have a higher expense ratio than ETFs. The company that manages an index fund takes a higher fee from the fund’s assets in order to compensate for the management that synchronizes the fund’s holdings with an underlying market index. ETFs are more passively managed, which results in a lower fee structure. Investors will pay brokerage commissions when they purchase and sell ETF shares, however, and those commissions can increase the expenses associated with ETF investments.

2. Minimum Investments. Like virtually all mutual funds, index funds have certain minimum investment thresholds, typically a few thousand dollars or more. ETFs impose low or nominal minimums because they are traded like shares of stock. An investor can purchase a single ETF share if he or she is so inclined.

3. Taxes on Investment Income. ETFs are generally considered more tax efficient than index funds because ETF shares are purchased and sold directly among investors in cash transactions. In contrast, an investor who wants to sell index fund shares will cause the fund’s management company to sell the fund’s underlying shares of stock, which can create capital gains tax consequences.

4. ETFs can be purchased and sold on an intraday basis whenever markets are open. This feature gives active investors an opportunity to take advantage of short term daily ETF price swings. Unlike ETFs, index fund purchases and sales are set at prices that are in effect when a market closes.