ASK A FINANCIAL PLANNER: 'What's the difference between an ETF and index fund?'

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Certified financial planner Sophia Bera answers:

What's the difference between an ETF and index fund, and which is better?

Great question. Before I delve into the specifics, let me give a little context as to why both can be good additions to an investment portfolio.

Two of the things that can help your investments weather a tough economy are time and diversification. Holding onto investments for years can mitigate the effect a volatile market has on your money. While the market may rise and fall, over a long time, you might still have positive average returns.

Diversification is really important, too. If you rely too heavily on one investment and that investment’s share price drops, you’re out a lot of money. But if you spread your investing dollars across lots of companies and industries, one company’s share price drop won’t affect your portfolio’s overall value too much.

Still with me? Good! Here’s how this pertains to both index funds and exchange-traded funds (ETFs). One thing they offer investors is instant diversification with little effort and expense. Every share of a fund you buy nets you shares (or fractional shares) in hundreds of companies at once. But they are different in a few ways.

Index funds

These are portfolios built to mimic the performance of market indexes like the S&P 500. You buy shares of an index fund, and the value of your shares rise and fall with the value of that index.

This makes them different from mutual funds, which are managed and rebalanced by fund managers (and their work costs money, leading to higher fees you pay to invest in the fund). Those fees are a percentage of your invested assets, so by using index funds instead of mutual funds, you’ll continue to save as your portfolio grows in size.

There are two downsides to index funds. First, their prices are set at the end of the trading day, regardless of what time of day you buy. This can limit your flexibility in buying and selling shares. Second, they often have initial investment minimums of a few thousand dollars, which can be cost-prohibitive to some investors.

ETFs

What is an ETF? Well, ETFs are sort of a hybrid — they trade like a stock, but they offer you the diversification of a mutual fund. Like index funds, you can use ETFs to invest in a variety of asset classes, like stocks, bonds, and commodities. But unlike index funds, ETFs give you more flexibility.

First, there are no investment minimums. Instead, you buy shares of an ETF just like you’d buy shares of a stock. Second, you can make trades on ETFs during market hours, while index funds are priced at the end of the trading day.

But there are some things to watch out for. While fees for ETFs are even lower than index funds, you can end up spending a lot on trade commissions if you make a lot of trades. Be mindful of how much your brokerage charges you whenever you buy or sell. And being able to trade ETF shares during market hours means the price per share can fluctuate while you’re thinking about buying or selling.

So which is better?

Truthfully, both index funds and ETFs have their upsides and downsides. And they are both excellent tools in an investor’s arsenal, allowing you diversification at a low price. What it comes down to is how much you have to invest right now, and what level of trading flexibility you’re looking for.

A good fit for many first time investors is Betterment because the company doesn't have any account minimums and wraps the trading costs in with management fees. I also like that once the money hits your account, it is automatically invested in the asset allocation you choose and you don’t have to go into the account and decide which index fund or ETF you want to purchase. Its user experience is far superior to other investment management platforms and it only takes 10 minutes to set up a new account.

Hopefully, this helps you get started investing!

This post is part of a continuing series that answers all of your questions related to personal finance. Have your own question? Email yourmoney[at]businessinsider[dot]com.

Sophia Bera, CFP® is the Founder of Gen Y Planning and has been quoted in The New York Times, Forbes, Business Insider, AOL, The Wall Street Journal, and Money Magazine. She tweets, travels, and loves helping millennials manage their money more effectively. Curious? Sign up for the free Gen Y Planning Newsletter.

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