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What’s an Index Fund & What’s an ETF?

Last week I posted a quick video from Fidelity that gave a nice overview of stocks and bonds for beginning investors.

I know a lot of people – beginning and advanced investors alike – have questions about index funds and ETFs (which, by the way, are great investment options for passive investors, especially when combined with a dollar-cost averaging strategy.)

So here are two short videos (2 minutes each) explaining what an index fund is and what an ETF is:

And if you really want to get crazy, here’s a slightly longer explanation of ETFs from BlackRock (4 minutes):

In summary,

What is an index fund? A fund is simply a group of smaller investments you buy in a single package. An index is just a measure of a financial market. So an index fund is a fund that mirrors a certain index. For example, the S&P 500 Index measures the stock performance of the 500 biggest companies in the U.S. You can buy an S&P 500 index fund from firms like Vanguard, Fidelity, or Charles Schwab that tracks the S&P 500 – giving you exposure to the stock performance of the 500 biggest companies in the U.S.
What is an ETF? An ETF, or exchange traded fund, is a fund that trades on a stock exchange – just like the stock of Google or AT&T. As a consequence of being on an exchange, ETF’s offer more liquidity than index funds (you can buy and sell ETFs during the day; you can only buy and sell index funds at the end of the day), which is perhaps the biggest difference between index funds and ETFs.

ETFs also offer lower minimum purchase requirements (you can buy as little as one share of an ETF; index funds sometimes have minimum purchase requirements of $3,000-$50,000 or more) and sometimes have lower expense ratios. There is also a more diverse universe of ETFs that you can choose from.

Should you choose an index fund or an ETF?

That decision really comes down to: (a) which index fund or ETF best represents the asset class you want to track (there may be plenty of index funds and ETFs that track the S&P 500, but you might have a tougher time finding an index fund than an ETF that tracks midstream oil companies), (b) which has a lower expense ratio, (c) what are the transaction costs involved, and (d) what are the tax implications.

Lastly, if you’re wondering what the best investment strategy is for “small investors who don’t have time to research individual companies“, I’ll leave you with this quote from Warren Buffett:

The best [strategy] in my view is to just buy a low-cost index fund and keep buying it regularly over time, because you’ll be buying into a wonderful industry, which in effect is all of American industry. If you buy it over time, you won’t buy at the bottom, but you won’t buy it all at the top either… People ought to sit back and relax and keep accumulating over time.