Index Funds vs ETFs: A Short Guide

The theory behind passive investing is that no single fund can beat the market over the long term, so gaining exposure to the market as a whole is a more efficient way of capturing returns. 

Investors can create an entire portfolio of passive investments, and still gain the same level of diversification as an active portfolio. Passive investments offer a pathway into the majority of the world’s markets, without the cost or complexity of many other investment types.

In this guide we look at the two main types of passive fund – index funds and ETFs.

What is an Index Fund?

An index fund is a type of low-cost investment with the following characteristics:

  • The fund is usually structured as a unit trust or OEIC (open-ended investment company). More units or shares can be created to meet demand, which means that the price generally reflects the value of the underlying assets. 
  • The fund tracks a particular market or index and aims to replicate the performance.
  • The fund is not actively managed, but simply follows the index. This can help to keep the costs low by limiting management and trading costs. 
  • The fund may track a single index, for example the FTSE 250 or the S&P 500. Alternatively, it could follow a combination of indices for a more diversified portfolio.
  • Like other fund types, index trackers may be available in accumulation shares (which reinvest dividends) or income shares (which distribute dividends as cash).

The main benefit of using an index fund, aside from the low costs, is diversification. Rather than choosing a few stocks from the market, you are investing in the entire market. The benefits of this are:

  • It avoids concentrating too much of your money in one area.
  • The underlying shares will not all rise and fall at the same time. Holding a wide variety of shares can help smooth out some of the volatility.
  • The portfolio will naturally tilt towards larger, more successful companies, as they will make up more of the index.
  • As there is no active management, there are no judgement errors or buyer’s regret.

What is an ETF?

An ETF (Exchange Traded Fund) works as follows:

  • ETFs offer another low-cost way of gaining access to a particular sector or market. 
  • An ETF is structured as a share, which can be bought and sold on the main stock exchanges.
  • It can track indices, collections of indices, or even the price of a particular commodity, for example, gold. 
  • The shares trade throughout the day, which means the price can fluctuate by the hour.

Some ETFs are actively managed, so it’s important to understand the structure, management style, and costs before you invest. 


Generally, when you invest in an index fund or an ETF, any income generated will be taxed as dividends. However, funds which invest mainly in fixed interest securities will produce an income which is taxed as interest.

When you sell your shares, any gains you have made will be subject to capital gains tax if your total profits exceed the annual exemption (£12,300).

What Are the Main Differences?

The main difference between index funds and ETFs is how they are traded.

Index funds are priced as of the close of business the day before. While you can buy the fund at any time, the actual trades only occur once per day. 

ETFs are traded like shares, and sales or purchases can be made at any point during the working day. This also means that the price can fluctuate over the course of the day.

The cost of buying index funds and ETFs can depend on the trading platform you use. ETFs may incur brokerage charges, while index funds usually do not.

Which Should You Invest in?

One of the main variables in choosing whether to invest in an index tracker or an ETF is availability.

Some investment vehicles, such as certain pensions, investment bonds or fund supermarkets, may not allow you to invest in ETFs. However, most will offer a reasonable range of index funds to choose from. 

Most full-functioning platforms or brokerage accounts will allow you to invest in either. This means that you will need to weigh up the investment options on their own merits, based on factors such as:

  • Cost
  • Performance, or how closely the investment tracks its selected index
  • Asset allocation
  • Risk level

What are the Disadvantages of Passive Investing?

Before committing to a passive investment strategy, it’s important to consider the risks as well as the benefits. For example:

  • It’s very difficult for a fund to replicate the index perfectly, and some degree of tracking error is expected.
  • A perfectly aligned tracker will, in fact, underperform against the market, as there are always costs to be taken into account. 
  • The headline cost is rarely the full cost. Remember to account for transaction and brokerage charges. If a fund is rebalancing frequently, these can add up. 
  • The shares making up the majority of the index have already made money, and may have reached their ‘peak’ or be overvalued. 
  • While it is rare for one active fund manager to consistently outperform the market, there are times when active management can be beneficial. 

What Are the Other Options?

Index funds and ETFs can both form part of a diverse investment strategy. You may also want to consider:

  • A passive fund of funds, which can hold a range of index trackers and ETFs within a defined asset allocation.
  • Multi-asset funds.
  • Actively managed funds.
  • Investment trusts.
  • Model portfolios which invest in a selection of funds (active or passive).
  • Bespoke portfolios which are constructed according to your requirements.

A well-diversified portfolio could hold ETFs, index trackers, and even a few actively managed funds. The key is to hold a wide range of assets which are invested (and maintained) at an appropriate risk level.

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Richard Martin-Redman