What are ETFs, index funds and mutual funds?
All three are pooled funds: many investors put money into one portfolio run by a registered adviser, and each share is a slice of everything the fund holds. That is the basket in the drawing below. The differences lie in the wrapper (how shares are bought and sold) and the strategy (who decides what the fund owns).
Hypothetical: you put $1,000 into Company A alone, or $1,000 into a fund of 500 stocks in which Company A is 0.2% of the fund. If Company A falls 50%, the single-stock position loses $500, while the fund loses about $1 from it. If the whole market falls 20%, though, the fund falls about 20% too: −$200.
- ETF (exchange-traded fund)
- A fund whose shares trade on a stock exchange throughout the day at market prices. You buy and sell them through a brokerage account, not from the fund.
- Mutual fund
- An open-end fund that sells and redeems its own shares at the next NAV calculated after your order, usually once each business day.
- Index fund
- A mutual fund or ETF that aims to match the return of a market index before fees, by holding all or a sample of the securities in it.
- Actively managed fund
- A fund whose adviser buys and sells holdings without following an index, usually trying to beat a benchmark.
- Expense ratio
- The share of a fund’s average net assets used each year to pay its operating expenses. A 0.20% ratio costs about $20 a year per $10,000 invested.
ETF vs index fund: why it is not either-or
People search “ETF vs index fund” as if they were opposites, but the two words answer different questions. “Index” describes the strategy: follow an index instead of picking stocks. “ETF” and “mutual fund” describe the wrapper. The SEC notes that both ETFs and mutual funds can follow either a passive or an active strategy.
So there are really four combinations: index mutual funds, index ETFs, actively managed mutual funds and actively managed ETFs. When people say “index fund”, they often mean an index mutual fund, as in the drawing at the top of this page. You cannot always tell from a fund’s name, so the SEC suggests checking the strategy section of its prospectus.
ETF vs mutual fund: how each is priced and traded
A mutual fund calculates its NAV (assets minus liabilities, per share) once each business day, typically after the major US exchanges close at 4:00 p.m. ET. Your order gets the next NAV calculated after it is received, so a buy placed at 11:00 ET fills at that evening’s price, which you do not know when you click. Orders after the cutoff get the next day’s NAV.
An ETF trades while the market is open, at whatever price buyers and sellers agree, which can sit a little above or below its NAV (a premium or a discount). Large firms called authorized participants create and redeem ETF shares in big blocks, and that arbitrage usually keeps the price close to NAV. Our US stock market hours guide lists the session times.
Hypothetical: an ETF quotes $50.00 bid and $50.02 ask. Buy 100 shares at market and you pay about $5,002; sell them at once and you get about $5,000, a $2 cost from the bid-ask spread alone. A thinly traded ETF quoting $49.80 / $50.20 costs $40 for the same round trip, and a market order in a fast move can fill worse. A limit order caps your price; see order types.
Costs: expense ratios, loads and trading costs
Every fund has an expense ratio, paid out of fund assets, so you never see a bill: it simply lowers your return in good years and bad. Index funds usually charge less than active funds because nobody is paid to research and pick stocks, but the SEC warns that not every index fund is cheaper, so check the fee table in the prospectus.
Hypothetical: $10,000 growing at an assumed 6% a year before costs for 25 years ends near $42,400 with a 0.05% expense ratio and near $33,900 with 1.00%, a gap of about $8,500 from fees alone. In a year when the market falls 10%, the fees are still charged: about −10.05% versus −11%. The ratio applies to the whole balance, growth included, so as growth becomes the bigger part of a regular investor’s balance (see the drawing), the same percentage costs more dollars. The 6% is an assumption; real returns vary and can be negative. Try your own numbers in the compound interest calculator.
- Mutual funds may add sales loads. In the SEC’s example, a 5% front-end load on a $10,000 purchase leaves $9,500 invested. Some also charge 12b-1 (distribution) fees, redemption fees or account fees.
- ETFs rarely charge shareholder fees, and 12b-1 fees typically apply to mutual funds, not ETFs. Instead you may pay a brokerage commission plus the bid-ask spread each time you trade.
- A “no-load” mutual fund charges no sales load but can still charge other fees.
Passive vs active: what you pay a manager for
An index fund aims to match its index before fees, so it trails the index slightly because of fees, trading costs and tracking error. An active fund has the potential to beat its benchmark, but the SEC notes that its performance depends heavily on the manager’s skill, and its higher costs are a hurdle it must clear first.
Hypothetical: the index returns 8% in a year. An index fund charging 0.05% keeps about 7.95%. An active fund charging 0.80% must earn about 8.75% before fees just to match it. In a year when the index falls 15%, the index fund loses about 15.05%; the active fund may lose less if the manager chose well, or more if not. Past results do not predict future ones.
Tax efficiency: the general US picture
In a taxable US brokerage account, funds pass realized capital gains on to shareholders, usually at year-end, and those distributions are generally taxable even if you did not sell a share. Because many ETFs swap securities in kind with authorized participants instead of selling them for cash, the SEC notes they typically make fewer capital gains distributions than mutual funds. Index funds of either type also trade less, which tends to mean fewer realized gains.
Hypothetical: you buy $5,000 of an active mutual fund in November, and in December it distributes $300 of capital gains from stocks it sold during the year. That $300 is generally taxable for the year, even if your shares are now worth less than you paid. Selling your own shares at a profit is a taxable event with either type.
Inside a tax-advantaged account such as a 401(k) or IRA, the SEC notes there is no tax difference between an ETF and a mutual fund. Tax rules depend on your situation and country; this is general information, not tax advice.
What a fund can and cannot do for your risk
A broad fund removes most of the risk that one company sinks your portfolio. It cannot remove market risk: when the whole market falls, a fund that holds the market falls with it. Funds are not insured by the FDIC or any other government agency, and you can lose money in any of them.
Not every ETF is broad, either. Some hold a single sector or even track a single stock. Leveraged and inverse ETFs are designed to hit their target on a daily basis, and the SEC warns that their returns over longer periods can differ significantly from that daily goal. Our portfolio diversification guide covers spreading risk across funds and asset classes, and leverage and margin explains why leverage multiplies losses.
ETF or mutual fund: which suits whom?
There is no single best type; it depends on how you invest, which account you use and what you are willing to pay. Buying ETFs to hold and trading them intraday are different activities: if short-term trading interests you, see the SPY day trading guide. UpTickFlow, our invite-only TradingView indicator, is built for intraday setups in liquid US stocks and ETFs on 5-minute to 1-hour charts; it does not pick funds or compare expense ratios. In general terms:
- Long-term investors in a taxable account often compare index ETFs and index mutual funds on cost, with ETFs typically more tax-efficient.
- People who invest a set amount every month may find mutual funds simpler: they buy straight from the fund at NAV with no bid-ask spread, and reinvesting dividends is usually easier than with ETFs. See dollar-cost averaging.
- Investors who want a manager’s judgment may choose an active fund, after comparing its total costs with a cheaper index alternative.
- Anyone who wants intraday prices, limit orders or the ability to sell during the session needs ETFs, held in a brokerage account.