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Index Funds vs. ETFs: What They Are And How They Work

Index Funds vs. ETFs: What They Are And How They Work

Years ago, investors bought and sold stocks in individual companies, often trying to beat the market’s average return. Then, in the early 20th century, the mutual fund — a single fund that held positions in multiple securities (usually stocks) chosen by investment managers (usually men) was born. Times change, of course. The market evolved again in 1976, and the first index fund became available.

So, what’s an Index Fund?

Consider index funds offspring of mutual funds designed to match the performance of an index, such as the S&P 500 or the Russell 2000. Rather than making active stock picks, these funds are passive. In other words, instead of a portfolio manager trying to select the most attractive stocks for a fund, an algorithm makes sure the fund adheres to its index, with the right representative shares of the right representative companies. When a new company gets added to the S&P 500, an index fund designed to match it automatically adds that company, too. 

Over time, investors in an index fund should enjoy a similar performance compared to that of the index itself. The bonus is that the lack of human input means a cheaper expense ratio (lower fee) for investors. “An index fund allows an investor to diversify among many different investments efficiently and generally at a low cost,” says Leslie Thompson, managing principal at Spectrum Management Group.

What Are ETFs?

It wasn’t until 1993 when exchange-traded funds (ETFs) were launched. ETFs are essentially funds that trade like stocks. They’re pools of stocks, commodities, currencies (or even crypto-currencies) that offer diversification at a very low cost. Investors like ETFs because they’re often cheaper than even very inexpensive index funds, and because they trade continuously. Index funds, like all mutual funds, are bought and sold just once at the end of the trading day at that day’s price. ETFs can be traded throughout the day (intraday) on the largest exchanges, and through virtually all online brokerage accounts. ETFs also tend to have a lower fee structure than index and mutual funds.

According to Matt Collins, Head of ETFs at PGIM Investments, “The beauty of ETFs is that if someone wakes up tomorrow and says, ‘I want to invest in robotics or the S&P 500,’ they can do it in 10 seconds. They can buy this sort of pooled investment vehicle through their brokerage account. I think that is sort of the crux of an ETF. It allows people to invest as they wish, in almost any segment of the market, and it’s low-cost and transparent.”

ETFs Are Regulated by The SEC

Yes, ETFs are also regulated by the SEC. “The process for launching an ETF is actually quite extensive,” Collins says. “The first stage is to set up a trust and that trust has to be approved by the SEC. It gives the parameters of how and what the trust may invest in. The trust then files to sell a product underneath that trust, and the SEC monitors the types of investments that can go to market. Then the final stage is approval from the stock exchanges, whether it’s the NYSE or NASDAQ or another. So you have the SEC and the exchange bodies overseeing that the ETF product is tradable.”

And all that active management that was a hallmark of the 1970s mutual fund? It’s part of the ETF world, too.  “Active ETFs are growing at a much higher rate than passive ETFs,” Collins says, “primarily because there were just a few active ETFs five years ago. I think what you’ll see over the next 10 to 20 years is a more evening-out. But the good news is that the cost of active management is coming down.”

How To Buy And Sell ETFs

“Almost anyone who knows how to use an iPhone, iPad, computer, anything,” Collins says, “can find out the value of an ETF.” If you don’t have a brokerage account, download an app and sign up for one. At E*Trade, for instance, ETFs are one of the investment choices. Click the link and you’ll get thousands of funds to choose from. You can see their history of performance, their Morningstar rating, the current market price, the fund’s expense ratio, and more. And E*Trade isn’t the only firm that allows this — most of the big brokerage firms do the same.

After you do your research, you’ll pick the fund you want, put in the amount you want to spend, click the “buy” button, and wait for confirmation of your purchase. (The confirmation usually comes within seconds, but if you’re just setting up your brokerage account for the very first time, it could be as long as 24 hours.)

And if you’re feeling a little overwhelmed at this point, try not to worry. To get a better grasp on all things stock market (buying, selling, trading and more) you might want to check out the InvestingFixx investing club, where you’ll learn Wall Street savvy and the investing confidence you need.

Finally, an important note for investors who are just getting started and are on a budget: Many funds will allow you to contribute a small amount to your portfolio each month so you can build an equity position without breaking your budget. Put it on autopilot. Visit it monthly. And — hopefully — watch it grow.