ETF vs. index funds: Key differences & how to choose the right one

You don't have to be a market expert to build real wealth for the people and goals that matter most to you. That's the whole idea behind passive investing. So, when it comes to ETFs vs. index funds, the real question isn't which one is better; both are generally low-cost, diversified ways to invest. It's which one fits how you invest, how you're taxed and what you're investing for. Understanding those differences can help you choose the approach that best fits your retirement goals and your family's future needs.

An index fund is an investment fund designed to track a market index rather than trying to beat it. Index funds are commonly structured as mutual funds, which are investment portfolios that pool money from multiple investors to purchase small pieces of stocks, bonds or money market instruments. Some index funds are structured as ETFs, which trade differently. More on that next.

While you can't invest directly in an index, you can invest in a fund tracking it. And instead of relying on a portfolio manager to actively pick investments, your fund follows a predetermined benchmark. Lower fees mean more of your money stays invested and working toward your goals, whether that's a more confident retirement, leveling up your kids' education or helping your favorite charity further its mission.

Index funds structured as mutual funds typically:

• Price once per day after markets close
• Are purchased directly from a fund company or brokerage
• Are commonly available in 401(k)s and retirement plans
• Often require a minimum investment

An ETF is a diversified portfolio of securities, like a mutual fund, but it trades throughout the day like a stock. Many ETFs track a market index, though some focus on a sector, a commodity or a specific strategy instead. The real difference between an ETF and a mutual-fund-structured index fund comes down to how you trade it.

ETFs trade on stock exchanges throughout the day, just like individual stocks. Their prices fluctuate as investors buy and sell shares.

Key characteristics of ETFs include:

• Often have no investment minimum beyond the cost of a share
• Fractional shares or one share can be bought
• Available through most brokerage accounts
• Frequently offer tax advantages in taxable accounts

Both index funds and ETFs support a passive investing strategy while helping you diversify your portfolio. The biggest differences come down to how they're traded, how they're taxed and how much flexibility they offer.

Here's what's behind each of these differences, and how they might matter for your own investing goals:

Because ETFs trade on exchanges throughout the day, you have more control and can buy or sell whenever markets are open. This flexibility can be useful if you prefer more control over execution prices.

Index funds, on the other hand, trade only once per day after markets close. You can receive the fund's closing net asset value (NAV), the total value of a fund's underlying holdings, divided by the number of shares, regardless of when the order was placed.

Expense ratios represent the annual percentage of assets used to cover operating expenses. And both ETFs and index funds are generally less expensive than actively managed funds. Index equity mutual funds averaged a 0.05% expense ratio, while index equity ETFs averaged 0.14%.^* That means you would have paid about $5 annually for every $10,000 invested in an index mutual fund versus roughly $14 for an ETF.

Because the goal of passive funds is to track an index, they require less management and typically charge lower fees. In some cases, an index fund expense ratio may be lower than an ETF’s. However, the difference is often small.

There are also costs beyond the expense ratio. ETFs can involve bid-ask spreads, which represent the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept. While often small, these costs can add up over time for frequent traders, particularly if there are commissions for each trade.

ETF shares also can be created or redeemed by authorized participants, helping keep the ETF's market price closely aligned with the value of its underlying investments.

Index funds do not have bid-ask spreads.

ETFs use an in-kind creation and redemption process that allows fund managers to transfer securities without triggering taxable capital gains inside the fund. As a result, you may receive fewer capital gains distributions.

Index mutual funds can sometimes generate taxable distributions when securities are sold within the fund. This difference matters most in taxable brokerage accounts.

However, in tax-advantaged accounts such as IRAs and 401(k)s, tax efficiency becomes less important because these accounts are already designed to defer taxes on investment gains.

If you are still in the middle of building retirement savings, this distinction may not significantly influence your decision.

Index funds often require minimum investments of $1,000. If you’re a new investor with limited cash, this could be a hurdle.

The good news is ETFs generally offer a lower barrier to entry. This option makes them particularly attractive for new investors. You often can purchase a single share or fractional share for just a few dollars. It’s like buying a slice of pizza if you can’t buy the whole pizza at once. And as more money becomes available, you can continue buying more slices.

One of the most convenient advantages of index funds is their compatibility with automated investing. You can set up recurring monthly contributions from checking accounts or payroll deductions. Because it’s automated, this could reduce the temptation to predict market movements.

While some brokerages now offer automated ETF purchases, the process is generally less seamless than with mutual funds. If you’re working on building consistent saving habits, index funds can become an "invisible" wealth builder by making it easy to invest automatically over time.

Neither is better across the board. The right one depends on your budget, your goals and how hands-on you want to be.
You may prefer an ETF if you:

• Invest through a taxable brokerage account
• Want more trading flexibility
• Are starting with a small amount of money

You may prefer an index fund if you:

• Invest primarily through a 401(k)
• Prefer automatic investing
• Want a hands-off approach that discourages frequent trading

You don't have to choose just one. Many people use both—a workplace retirement plan for automatic, hands-off investing, and ETFs in a taxable account for flexibility.

Whichever you choose, low-cost passive investing helps more of your money stay invested and working toward what matters most, whether that's supporting causes you care about, taking care of the people you love or building the retirement you want. Even small differences in cost can add up over time, so if you're unsure which option fits your goals, a Thrivent financial advisor can help you build a strategy around your full financial picture.