Trading methods, fee structures, and liquidity differ between index funds and ETFs. At the end of the trading day, index funds can be traded at NAV (net asset value), whereas ETFs trade in real-time like shares. For example, the S&P 500 index fund trades daily at NAV, while one can buy or sell SPY on any given trading day up to hundreds of times. In 2022, SPY had an average daily volume of over 79 million shares, indicating high liquidity. For fees, the average expense ratio for ETFs in 2022 was 0.19%, while index funds averaged 0.09%, with SPY itself having an expense ratio of 0.09%. Actively managed funds had an average expense ratio of 0.74%. Trading ETFs incurs a bid/ask spread of about 0.02%, which index funds do not have.
Index Funds
An index fund is a type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the S&P 500. Total assets under management (AUM) in index funds now surpass $7.5 trillion globally, with over $3 trillion allocated to U.S.-based indices since their inception in 1976. These index funds reduce management costs because they have the same investments as their benchmark index. For example, the S&P 500 index fund holds Apple Inc., Microsoft Corp., and Amazon.com, three of the tech’s biggest powerhouses that together make up over a fifth of its entire market capitalization.
In 2022, index funds had an average expense ratio of 0.09%, compared to actively managed funds that averaged 0.74%. This results in a low expense ratio and higher net returns for investors. Over the last 35 years, the S&P 500 index fund had an average annual return of over 11.6%, while actively managed funds only achieved about 8.7%. An investor who invested $10,000 in the S&P 500 index fund in 1980 would end up with over $1 million by 2023, while an actively managed fund would yield only $370,000.
Index funds achieve diversification and reduce individual stock risk by holding a large number of constituents. The S&P 500 index fund holds stocks from the top 500 companies like Apple, Microsoft, and Amazon. Individual stocks have a 30% volatility, says Standard & Poor’s, while the S&P 500 as an aggregate has around 18%. Over the past 30 years, the S&P 500 index has had only seven years of negative returns, with positive returns in the other 23 years. Index funds are a cost-effective, high-return, risk-diversified investment suitable for long-term investing.
ETFs
ETFs (exchange-traded funds) trade on stock exchanges like stocks. Since the first ETF launched in 1993, the global ETF market has grown to over $10 trillion in total assets, with over 60% originating from the U.S. Typically, ETFs follow market indices like the S&P 500 and NASDAQ 100. The S&P 500 ETF (SPY) is one of the largest ETFs globally, managing over $400 billion. In 2022, SPY’s average daily trading volume surpassed 79 million shares.
In 2022, ETFs had an average expense ratio of 0.19%, slightly higher than index funds at 0.09%, but lower than actively managed funds at 0.74%. SPY’s expense ratio is 0.09%, similar to many index funds. Since 1993, the S&P 500 ETF has had an average annual return of about 9.8%, higher than many actively managed funds. An investor who invested $10,000 in SPY in 1993 would have nearly $190,000 by 2023.
ETFs achieve diversification and minimize individual stock risk by holding various constituents. The NASDAQ 100 ETF (QQQ) holds stocks of the top 100 tech and non-financial companies like Apple, Microsoft, and Amazon, making up more than half of its total market value. The overall volatility of the NASDAQ 100 index is about 20%, while a single tech stock has around 35% volatility. Over the past 20 years, the NASDAQ 100 index had an average annual return of about 13.4%, outperforming many actively managed funds. ETFs are flexible, efficient, and cost-effective, making them essential for modern investment portfolios.
Main Differences
Index funds and ETFs have significant differences in trading methods, fee structures, and liquidity. Index funds trade at NAV at the end of the trading day, while ETFs trade in real-time on stock exchanges. For example, the S&P 500 index fund trades daily at NAV, while SPY ETF can be traded multiple times during trading hours. In 2022, SPY’s average daily trading volume exceeded 79 million shares, indicating high liquidity. Index funds, on the other hand, have lower liquidity.
In terms of fees, ETFs are slightly more expensive than index funds but cheaper than actively managed funds. In 2022, ETFs had an average expense ratio of 0.19%, while index funds had 0.09%, and actively managed funds had 0.74%. SPY’s expense ratio is 0.09%, similar to most index funds. ETF trading incurs trading commissions and bid-ask spreads; for example, each SPY trade incurs a spread of about 0.02%, while index funds typically do not have these costs.
Both index funds and ETFs reduce individual stock risk by holding a large number of constituents. For example, the S&P 500 index fund and SPY ETF hold stocks of 500 large U.S. companies, such as Apple, Microsoft, and Amazon, making up over 20% of the market capitalization. Individual stocks have a 30% volatility, while the S&P 500 index has an overall volatility of 18%. Diversification reduces risk and provides good returns. Data shows that in the past 30 years, the S&P 500 index had only seven years of negative returns, with positive returns in the other 23 years. Index funds and ETFs provide low-cost, high-return ways to diversify risk, but ETFs offer trading flexibility not available with index funds, allowing for better tax-loss harvesting opportunities.
