Index Funds vs ETFs

March 28, 2022

Index funds and exchange-traded funds (ETFs) are popular investment products. Index funds and ETFs are frequently passively managed and therefore viewed as a lower-cost alternatives to actively managed funds. 

Exploring Index Funds and ETFs 

A mutual fund that tries to track an index, such as the S&P 500 or Dow Jones Industrial Average, is known as an index fund and tracks the index’s performance.

An index ETF also tries to match the index’s performance it tracks. ETF index funds are passively managed like index mutual funds, allowing investors to participate in all index movements.

While index funds and index ETFs have the same investment goal, they attain it differently.

The following are some of the key distinctions between index ETFs and index funds:

  1. ETFs trade all day, while index funds only trade at market closing.
  2. When purchased commission-free, ETFs are frequently less expensive than index funds.
  3. ETFs can be more tax efficient.
  4. Index funds frequently have larger minimum investments than ETFs.
  5. Index funds can be purchased in dollar increments, unlike ETFs, which the share must purchase.

How are Index Funds and ETFs traded?

The most significant distinction between index ETFs and index funds is how they are traded. 

You purchase and sell fund shares directly through the fund manager with index funds. Price is based on the fund’s net asset value at market close. NAV is the entire worth of the fund’s assets minus total liabilities divided by the number of shares outstanding.

Index funds allow investors to purchase shares in set dollar amounts or share amounts. Instead of buying five shares, you might just choose a dollar amount and be allocated the appropriate number of shares.

You can only purchase and sell ETFs on a per-share basis. However, they trade continuously throughout the day like stocks. Limit orders and stop orders can also specify a price threshold that you’re ready to accept or pay.

ETFs are generally more liquid than index funds because they trade intraday, whereas index funds only trade at market close. However, this dynamic does change with low-volume ETFs. Because index funds trade directly with the fund manager, there is often more liquidity.

Furthermore, ETFs have a distinct advantage over mutual funds in tax efficiency in terms of tax advantages. Because mutual funds trade directly with their managers, the manager may need to sell shares of the fund’s investments to cover redemptions. As a result, mutual funds purchase and sell inside the fund more frequently than exchange-traded funds. And every time the trades result in net capital gains within the fund, investors are hit with a tax bill.

This regulation does not apply to ETFs. On the other hand, ETF investors are only taxed on their capital gains when they sell their shares.

This post is for informational and educational purposes only. It is not intended to be investment advice and should not form the basis of an investment decision.

Masterworks is a fintech company democratizing the art market. Our investors are able to fractionally invest in $1mn+ works of art by some of the world's most famous and sought-after artists.