An index fund attempts to follow a specified market index; an exchange-traded fund, or ETF, is a fund whose shares trade on an exchange. Those descriptions answer different questions. An index strategy can be used by an ETF or a mutual fund, and an ETF can follow strategies other than an index. Neither label establishes that a fund is cheap, diversified enough for a particular person, or protected from loss.
For U.S. investors, the useful starting point is the prospectus: identify the index or strategy, the assets held, the fees and the material risks. A familiar fund name is a starting clue, not a substitute for reading those details. This guide explains how to compare the moving parts without suggesting a particular investment.
What an index actually represents
An index is a defined collection or measurement of securities. Its rules determine which securities qualify, how they are weighted and when the collection changes. A broad index may contain many companies, while a narrowly defined sector, country or theme may be concentrated in a small slice of the market. Owning many securities does not eliminate the possibility that they fall together.
A fund may buy all securities in an index or use a sample. Its return can differ from the index because of expenses, trading, cash holdings and imperfect tracking. An index fund may have less flexibility to avoid declining securities because its mandate is to follow the index. Past results cannot establish what will happen next.
The costs inside the fund
The expense ratio summarizes annual operating expenses as a percentage of fund assets. These expenses are generally deducted from fund assets and reduce returns; they are not normally a separate bill. A lower ratio helps the investor keep more of a given gross return, but comparing ratios alone can obscure differences in holdings, strategy or other charges.
Review the standardized fee table in the prospectus and check the correct share class. Some mutual fund classes can carry sales charges or other shareholder fees. A fund's fee arrangements can change, so use current documents rather than assuming a figure found in an old article still applies. The SEC's fee bulletin describes the categories and their effect on returns.
The costs of trading ETF shares
ETF shares generally change hands at market prices during trading hours. That price can differ from the fund's net asset value, the per-share value of its assets less liabilities. A premium or discount can change between purchase and sale, affecting the outcome. Market prices can also move while an order is pending.
The bid is the price a buyer offers and the ask is the price a seller requests. The difference, or spread, is a trading cost that may be especially consequential for small trades or less active markets. Brokerage commissions, if charged, are another cost. A commission-free trade does not make the spread disappear. A limit order specifies an acceptable price but may not execute; a market order seeks execution without fixing the price.
A comparison checklist
- Read the index rules and top holdings; look for concentration and overlap with existing holdings.
- Compare the prospectus expense table and any account, transaction or advisory charges.
- For an ETF, inspect the spread and historical premiums or discounts, recognizing that both can change.
- Read the principal risks and understand whether the fund uses leverage, derivatives or a specialized strategy.
- Consider when money may be needed and whether the potential losses fit the investor's circumstances.
What the labels do not promise
Fund shares can lose value. ETFs and mutual funds are not FDIC-insured deposits, even when purchased through a bank or brokerage. Diversification can reduce exposure to an individual holding but cannot eliminate market risk. Costs matter most when compared on equal terms: two funds following different indexes can behave very differently even if their expense ratios are similar.
Keep the documents with the date of your review and revisit the decision if a fund changes its strategy or your circumstances change. The prospectus, shareholder report and broker's current fee schedule are better foundations for a comparison than a recent return alone. The relevant protections and tax rules may differ outside the United States.
When comparing two funds, also look at the accounts in which they would be held and the brokerage services needed to buy or sell them. Taxes and account fees can affect the investor’s outcome, and a fund’s headline expense ratio does not describe every cost in every account. A prospectus and account agreement serve different purposes; read both.