What Is the Difference Between an Index Fund and an ETF?

Today’s topic: understanding the difference between index funds and ETFs. We’ll explore what each of these investment vehicles are, their pros and cons, and how to decide which one might be the best fit for your portfolio.

What Is an Index Fund?

An index fund is a type of mutual fund designed to mirror the performance of a specific market index. One of the most popular examples is the S&P 500, which represents the 500 largest companies in the U.S. These funds are cap-weighted, meaning your investment is proportionally allocated to each company based on its market size. So, larger companies like Apple or Microsoft make up a bigger part of your portfolio than smaller ones.

The core idea behind index investing is simple but powerful: instead of trying to pick individual winners, you invest in the whole market (or a large segment of it) and benefit from overall market growth. Studies have shown that this approach often outperforms actively managed portfolios over the long term. Beyond the S&P 500, there are many other indexes — like the Dow Jones (30 large U.S. companies), the Russell 2000 (small-cap stocks), or international ones like the EAFE index.

When we talk about index funds here, we’re specifically referring to index mutual funds — which come with their own unique features.

What Is an ETF?

ETF stands for Exchange Traded Fund, and while many ETFs also track indexes, they operate quite differently than mutual funds. The very first ETF, launched in 1993, was SPY — an S&P 500 ETF from State Street. It was created in part as a response to the 1987 market crash, aiming to offer more liquidity and flexibility in trading.

Unlike mutual funds, ETFs can be bought and sold throughout the trading day, just like stocks. This gives investors more flexibility and access to real-time pricing. As of now, there are over 12,000 ETFs on the market, ranging from index-based to actively managed strategies.

Key Differences Between Index Funds and ETFs

So how do index mutual funds and ETFs compare? Let’s break down some of the most important differences:

1. Trading Flexibility

• Index Mutual Funds: Trades are executed at the end of the trading day at the fund’s closing price.

• ETFs: Trade throughout the day like stocks. You can buy or sell them multiple times daily if needed.

2. Liquidity and Pricing

• ETFs provide real-time pricing with a bid-ask spread. The spread is usually small for highly traded ETFs, but it's still something to consider as it can impact your overall cost.

• Mutual funds don’t have a spread, but your trade is locked into the closing price, regardless of when you place it.

3. Tax Efficiency

• One of the downsides of mutual funds is capital gain distributions. Even if your fund’s value hasn’t increased, you might still get hit with a tax bill due to internal sales made by the fund manager.

• ETFs are generally more tax-efficient because of their unique structure, which allows in-kind redemptions that minimize capital gains.

4. Expense Ratios

• Both ETFs and mutual funds have an internal cost known as the expense ratio. Even when tracking the same index (like the S&P 500), these costs can vary.

• For example, while SPY is one of the most traded ETFs, it doesn’t have the lowest cost. A similar ETF, SPLG, also tracks the S&P 500 and offers a lower expense ratio — a crucial consideration for long-term investors.

Check out this week’s episode on: Five Reasons to Roll Over Your Old 401k Into an IRA

Choosing Between an Index Fund and an ETF

Your best choice depends on your investment goals and account type.

• If you're investing through a 401(k), you're more likely to see index mutual funds offered, since ETFs are rarely included in employer plans.

• For IRAs or brokerage accounts at firms like Vanguard, Schwab, or Fidelity, you’ll likely have access to both ETFs and mutual funds. If that’s the case, ETFs may offer better long-term tax efficiency and lower costs — especially for taxable accounts.

Another tip for ETF investors: use limit orders instead of market orders. This lets you control the price you pay and helps avoid overpaying due to temporary price fluctuations.

Final Thoughts

Index funds and ETFs share the same basic philosophy: invest broadly, stay diversified, and keep costs low. But their structure, tax treatment, and trading mechanics can be quite different. Knowing these distinctions can help you make smarter investment choices tailored to your specific financial situation.

If you have a question or topic that you’d like to have considered for a future episode/blog post, you can request it by going to www.retirewithryan.com and clicking on ask a question. 

As always, have a great day, a better week, and I look forward to talking with you on the next blog post, podcast, YouTube video, or wherever we have the pleasure of connecting!

Written by Ryan Morrissey

Founder & CEO of Morrissey Wealth Management

Host of the Retire with Ryan Podcast