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Index Funds vs. Index ETFs: The Difference Is In The Trades

Mutual funds and exchange traded funds that follow an underlying benchmark index provide a passive way to gain broad market exposure. While the destination is the same, the investor should understand the differences between the two routes.

Index funds, like all other mutual funds, are bought and sold through the fund company, with shares priced once at the end of the trading day, writes Elliot Raphaelson for Chicago Tribune.

On the other hand, ETFs are traded through brokers on a secondary market. Consequently, the shares can be bought or sold throughout the trading day at up-to-date market prices, like any normal company stock.

ETFs also have no restrictions on the frequency of trades. Investors can use margins, sell short, utilize stop orders, implement limit orders or trade an open order, basically all the trading options associated with stocks. More aggressive traders who like to time their investments can now utilize ETFs to access broad and niche markets. [Don't Confuse ETFs and Index Mutual Funds]

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While the ETFs typically show lower expense ratios than mutual funds, investors also have to consider other direct trading costs. Since investors would have to trade ETFs on a brokerage account, broker fees will apply for every transaction.

Brokerage fees can add up as investors buy and sell positions. For instance, investors will have to consider commission fees when reinvesting earnings, dividends or capital gains, or when rebalancing an investment portfolio. However, a number of brokers have partnered with providers to offer commission-free trades on a number of ETFs, which should help long-term investors rebalance some ETF holdings at no cost. [Six Popular Commission-Free ETF Trading Platforms]

Along with direct costs, investors should also be aware of indirect costs to trading ETFs, like the bid-ask spread associated with each transaction. The bid-ask spread, or simply the spread, is the difference between the bidding price and asking price of a security, which is determined by basic market supply and demand. More buyers translates to more bids and more sellers translates to more asks. In any highly liquid market, there will be a lot of sellers and buyers, which would contribute to a tighter spread. [Bid-Ask Spread]

For more information on ETFs, visit our ETF 101 category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.