Index funds vs ETFs: the differences explained

What are index funds and ETFs?

To explain the differences between an index fund and an ETF, we first have to define what we mean by each term.

ETF, or exchange-traded fund: for the purposes of this guide, we’re defining an ETF as a passively managed fund that aims to track an index. An index is simply a list of businesses – like the 500 biggest companies in the US (the S&P 500) or the 100 largest on the London Stock Exchange (the FTSE 100).

When a fund is passive, it isn’t trying to outsmart the market. Instead of a manager deciding what to buy or sell, it simply mirrors the makeup of its chosen index. If the index changes, the fund automatically adjusts to match.

Index fund: we’re defining “index fund” as a mutual fund that also tracks an index. They do the same job as an ETF – following the performance of a particular list of companies – and are also typically passive. However, they work slightly differently behind the scenes, as we’ll explore below.

So, what we're really looking at here is the difference between index mutual funds and ETFs – same destination, different engines. Both aim to track the market, but work slightly differently.

The differences explained

The most significant difference between index mutual funds and ETFs is when they can be bought and sold.

ETFs can be bought and sold throughout the trading day, just the same as individual stocks. In fact, in your broker platform, you'll see live prices that move up and down in real time – reflecting what other investors are willing to pay (or accept) at that exact moment.

There’s usually also a small difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept, known as the spread.

Index mutual funds, on the other hand, are only priced once per day, after the market closes, based on their net asset value (NAV).

Another key difference is cost structure. Index mutual funds tend to have minimum investment requirements, which can often be quite high. Take Vanguard's Active UK Equity Fund, for example, which requires an initial one-off payment of at least £500.

In contrast, you could invest in the Vanguard S&P 500 ETF for as little as £1 through some brokers.

ETFs also tend to have slightly lower ongoing fund costs, too – though this isn't always the case with specialised or niche funds.

It's also worth noting that ETFs don't always track an index, though the majority do. Some are actively managed.

Why choose an ETF over an index mutual fund?

ETFs are basically the democratised version of old-school index funds. They tend to be much more accessible, for a variety of reasons:

• No minimum investments: you can buy ETFs for as little as £1.
• You always know the price you're paying: ETF prices update in real-time, index fund prices only update once per working day. The price you pay for index mutual funds is calculated after the trading day has ended.
• You can trade with more flexibility: ETFs are bought and sold on an exchange, so you can buy and sell as often as you'd like.
• After-hours trading: index mutual funds only trade once per day, five days per week, during the stock market's opening hours. ETFs can be traded out of hours.

Buying ETFs is a more familiar user experience for most investors, whereas investing in an index mutual fund can be slightly more confusing and overwhelming for beginners.

When you try to buy an index ETF, it's similar to buying shares or using a cryptocurrency exchange – you see the current price and you place your order. Assuming there's enough liquidity (enough people wanting to buy at any given time), your order will go through.

For example, here's how it looks on the stock and ETF platform Trading212 when looking at Vanguard's S&P 500 Accumulation fund (VUAG):

It shows the current price, a price chart, and a buy button.

The downside to exchanges is that they can drive some people to act on sentiment.

Price fluctuations can lure people into a path of attempting to "day trade" – and less than 1% of day traders are able to "predictably and reliably earn positive abnormal returns".

If you're planning to invest long-term (10+ years) and on a regular basis (e.g. every month), it won't make much of a difference whether you invest at the end of the day or during the day.

With index mutual funds, you don't actually know the price you're paying because the price is calculated and orders are placed at the end of each trading day. Everyone that buys and sells on the same day gets the same price.

The founder of Financial Interest and Damien Talks Money, Damien Jordan, exclusively invests in index ETFs rather than index mutual funds:

"In my opinion, there's very little advantage to index mutual funds over ETFs," Damien says. "Everything an index mutual fund can do, an ETF can do. There's so few differences and an ETF can be cheaper and easier to buy, which is why they tend to be more popular with everyday investors like myself."

But of course, what's right for Damien might not be right for you. The suitability of index mutual funds or ETFs depends on every individual investor's needs and goals.

Why choose an index mutual fund over an ETF?

• They're more established: they've been around for longer, so could be considered safer.
• More specific products: can be fine-tuned to a specific investor's needs.
• Varying strategies: you can automatically change investments over time, for example when retirement planning.

In general, index mutual funds can offer better tailoring and support for inexperienced investors or those that want to be totally hands-off, and don't want the temptation to act of short-term market fluctuations.

You also don't have to worry about spreads – everyone who buys or sells on the same day gets the exact same price.

P.S., If you're looking to compare fees and funds across different leading brokers in the UK, you should check out our free index fund cheat sheet. Sign up below and we'll send it right over.

Which one is safer?

Both index mutual funds and ETFs are equally safe, as your investments should always be covered by FSCS protection. The "risk" could come from where you choose to invest. For example, a fund that tracks the US market might be considered less risky than one tracking emerging markets, or a bond fund might be considered safer than an equity fund.

Does it matter which one you choose?

The bottom line is that both index mutual funds and ETFs can give you the ability to passively invest in hundreds or thousands of businesses at the same time.

In the UK, both types of fund can be invested in via a stocks & shares ISA or a SIPP, allowing you to invest tax-free, with no capital gains on any profits made if you stay within your allowances.

If you're unsure which one to choose – and especially if there's a lot of money on the line – it can be a good idea to speak with a qualified financial adviser.

And if you want to learn more about index funds and ETFs, we highly recommend checking out:

• Our beginner's guide to ETFs
• Our beginner's guide to index funds
• Our guide to choosing an index fund
• Our index fund provider cheat sheet, to compare brokers, fund options and fees
• Our free index funds for beginners course, hosted by Damien from Damien Talks Money.

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