When looking at ETFs vs index funds there are a number of differences and similarities. It helps to know what an ETF and index fund are to best understand the differences between them. An index fund is a fund (usually a mutual fund but can also be an ETF) which tracks an index such as the S&P 500 or Dow Jones. An ETF (Exchange traded fund) is a fund that trades similarly to a stock, through a brokerage account, and is an investment fund which holds a number of assets, which can follow an index but could also be invested in other assets depending on the strategy of the ETF. They can both play an important role in an investor’s portfolio and understanding the similarities and differences will help to ensure they’re used well, when building a portfolio.
Key Features of ETFs
ETFs (Exchange Traded Funds) are chosen by both passive and active investors because of their flexibility and the variety of options they provide. ETFs can hold investments such as stocks, bonds, commodities, or mirror the performance of a benchmark index (aka index fund). They can be structured to track anything, from an individual commodity’s price to a large, diverse collection of securities, and can also be leveraged such up to 2x or 3x the value of the underlying asset. Investors tend to use ETFs to build exposure to specific sectors in the market, such as utilities, healthcare, technology, etc.
The term ‘exchange-traded’ is important and a key feature, as ETFs are traded on exchanges the same way as stocks and can be traded throughout the day. Conversely, mutual funds are settled and traded once per day, at the end of the trading day.
An investor should consider adding ETFs to their portfolio if:
- Want to purchase through a brokerage account.
- You want tax efficiency, as there is not a lot of buying and selling within a passively managed ETF which means lower capital gains taxes.
- You want exposure to certain sectors or don’t want to build a portfolio yourself, from individual stocks.
- Flexibility to invest in individual sectors or assets without buying the ‘whole market’ like with an index fund.
Key Features of Index Funds
Index funds are purchased directly through investment companies, unlike ETFs that are purchased through an exchange, like stocks on the stock market. One of the main reasons investors favour index funds is that they tend to be hands-off, low-cost, and easy to invest in as they are usually purchased through an Investment Advisor. Unlike ETFs, this investment vehicle doesn’t have trading commissions but usually has other fees and costs.
An investor should consider index mutual funds to their portfolio if:
- They want the entire investing process managed by someone else. Index mutual funds can be purchased through an Investment Advisor who can help you determine which fund(s) are right for you.
- They are looking for a long-term investment that doesn’t need a lot of attention to manage. A ‘set-and-forget’ type of investment.
- Don’t want to have to worry about diversification risk as you’re investing in the ‘whole market’.
What Do ETFs And Index Funds Have In Common?
Index funds were first developed and made available for investment in 1976. They were developed and introduced by Jack Bogle, who launched the first index fund known as the Vanguard 500 Index mutual fund which emulated the S&P 500 index.
ETFs on the other hand were developed in 1993. Over the years ETFs have become increasingly popular. One of the reasons for this is due to their structure which gives them a number of advantages over mutual index funds. For starters, ETFs generally have a passive management style which results in lower expense ratios, unlike mutual funds. Even so, there are some merits to mutual funds which make them a favorite of retail investors.
Some of the features that they have in common are:
Diversification: Both index funds and ETFs are funds that are invested in a number of different assets so they can both provide good diversification to any portfolio.
Management: ETFs and index funds are both managed funds. Most ETFs and index funds are passively managed, meaning that the managers aren’t actively researching and analysing stocks and tend to stick to either the investment strategy of the fund or what stocks are in the index that they are following. Compared to other mutual funds which tend to be actively managed.
Fees: Both ETFs and index funds tend to have lower fees than actively managed mutual funds, which is one of the main features that has made them so popular. In an actively managed fund (like mutual funds), as mentioned there are professional portfolio managers which make the investment decisions which means that there are more expenses in an actively managed fund which means higher fees. But in the case of passively managed investments such as an index fund (and most ETFs), there are lower fees, also known as the expense ratio. In 2019, the average annual expense ratio for actively managed funds was 0.66%, whereas, for passively managed funds, the ratio was 0.13%.
What Are The Differences Between ETFs and Mutual Funds?
The main difference between ETFs and index funds are the fees and how each type of fund is purchased. Since you can buy and sell ETFs like stocks, you have to pay a commission each time you trade. Depending on the broker and the amount being invested the commissions can add up over time and reduce your investment’s return (some brokerages offer commission-free ETFs). Index funds, on the other hand, are sold without commissions but have loading fees, generally when the fund is sold. These loading fees vary between companies and it’s important to understand all fees before investing index funds or ETFs.
Dividend distribution is another factor that differentiates index funds from ETFs. Whereas you can choose to reinvest the dividends paid by index funds directly back into the fund, you cannot do the same with ETF dividends. But in saying that, once an investor receives dividends paid by an ETF they can choose to purchase more shares if they wish.
Investors should also bear in mind the annual expense ratios. As a rule of thumb, the higher the expense ratio, the lower the investor’s total returns. Generally, ETFs have a lower expense ratio than index mutual funds. This is an important consideration as the fees are paid regardless of the performance of the fund.
Initially, ETFs used to have the edge over index funds as you could start investing in ETFs with as little as one share. But more and more companies are lowering or eliminating the minimum investment requirement for investing in index funds.
Index funds and ETFs also differ in terms of tax. Although both vehicles are tax-efficient, an index mutual fund will incur less capital gains taxes than an actively managed ETF as there is less buying and selling happening within the fund.
Lastly, ETFs are more liquid than index funds. As mentioned earlier, you can buy and sell ETFs anytime the stock market is open. But with index funds, you’ll have to wait after the end of the trading day, when the market closes, for a purchase or sale to settle. This means that the investor doesn’t know the price at which they sold or purchased until the next day. Markets usually close at 4 p.m EST so any transaction will settle after 4pm. This is important if considering actively trading ETFs or index funds, but for long-term investors, it’s not as important.
ETFs and Index Funds: Which Should You Choose?
Both mutual funds and ETFs can fall into the bracket of index investing because, depending on which fund is chosen they track an underlying benchmark index. One of the reasons that index funds are popular is that they often beat actively managed funds in the long run. In the short-term, sector specific ETFs can provide excellent returns and outperform a passively managed mutual fund or ETF, if economic and market conditions support the sector.
Both index funds and ETFs depend on a passive investment strategy. This strategy is not designed to beat the market and therefore removes the risk of losing to the benchmark index. Investors applaud ETFs because they bring diversification. But it’s important to note that diversification doesn’t mean that ETFs are not vulnerable to volatility. If you opt to go for ETFs, the idea is to understand what the ETF index is tracking and the underlying risks associated with it.
If investing over the long-term, then index funds are should likely make up at least part of your portfolio. But if an investor sees an opportunity in a specific sector which is likely to outperform in the short-term then it could be advantageous to invest in a sector specific ETF. There’s no right and wrong answer when it comes to choosing between index funds and ETFs, the choice between the two comes down to a few factors which are different for every investor: fees, risk profile and overall investment strategy. The strategy with choosing either is about creating a portfolio that meets your needs, which could mean holding both.
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