Index Funds vs ETFs: Which is Better?

By Chika

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Last Updated: September 6, 2021

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When faced with an investment decision, one of the questions that repeatedly gets thrown in our face is the choice of an asset class. Knowing which asset class to invest in requires an understanding of the unique attributes of the asset and if it helps us achieve our investment objectives. While some assets are similar, others are different and inversely related. Exchange-traded funds (ETFs) and index funds are great investment vehicles for investors seeking exposure to the stock market.

 However, there tends to be a lot of confusion surrounding these asset classes as investors tend to mistake one for another. This article deals with two asset classes that are so similar that sometimes they are mistaken for another – index funds and ETFs. It explains the similarities, differences, and when each suits your investment objectives.

 

What are Index funds?

An index fund is a type of mutual fund whose composition is designed to track the performance of an index such as the S&P 500, Dow Jones Industrial Average, Russell 2000, or Nasdaq.  It is an easy way to buy the whole market or a sector. Rather than rummaging through a long list of stocks to find a suitable one to invest in, one can invest in index funds.

Investing in index funds is a hands-off passive investment strategy for investors hoping to build a diversified portfolio. Investors in index funds don’t try to beat the market, but rather aim to replicate the performance of the market.

 

What Are Exchange-Traded Funds?

An exchange-traded fund is a fund that contains a basket of stocks that are traded like one security. An ETF may be composed of different stocks. Rather than invest in each stock, the investor invests in the ETF. The fund provider designs a fund that tracks the underlying assets which he owns and then sells shares in that fund to investors. Inadvertently, what the shareholders own is a portion of the ETF, not the actual shares. Exchange-traded funds trade on exchanges and can be bought and sold like stocks. Depending on the fund and the stock composite, investors may get dividend payments.

 

Similarities Between ETFs and Index Funds.

Basket of securities 

ETFs and index funds both share many similarities. Firstly, both investment vehicles lump different securities together into a single financial product (fund) in which people can invest. This allows investors  to take advantage of market volatility and benefit from the price movement of these securities without owning them directly. 

 

Diversification

Secondly, they offer investors a diversified portfolio because they contain different securities.  For example, an ETF or index fund which tracks the Nasdaq would offer the investor exposure to stocks in that index which are mostly technology stocks.

 

Lower management cost

Because the securities are lumped into one investable financial product which is managed passively, the management fees are usually lower than when dealing with individual securities or actively managed funds like mutual funds where a broker readjust the portfolio of securities frequently.

 

Long-term returns

Investments are passively managed; they tend to have strong long-term returns than funds that are actively managed which perform better in the short term. The Stock market has historically shown positive returns. For example, in the last 10 years, the average return of the S&P 500 is 12.4%.

Actively managed funds perform better in the short term because fund managers make investment decisions based on current market conditions and the fund composite accordingly. However, the probability of posting consistent, market-beating decisions over a long period can lead to lower returns over time.

 

The differences between index funds and ETFs

Trading pattern

The major distinction between ETFs and index funds is the way they are traded. While index funds are traded based on the price set at the end of the trading day, i.e. after the market has closed. ETFs on the other hand trade much like stocks and can be bought and sold when the market is in session.

 

The minimum start-up investment

ETFs require a lower minimum investment than index funds. All it takes is to buy one share of an ETF. Some brokers offer fractional shares to investors on their platform which means investors can buy in amounts below the price of one share unit.  On the contrary, index funds require a minimum amount before one can invest in them which can be higher than a typical share price. As an example, you need to have a minimum investment of $3,000 to invest in Vanguard Index funds.

 

Tax efficiency

ETFs are generally more tax-efficient than index funds. When you sell an ETF, you are selling directly to another investor. Capital gains taxes accrued from the trade are yours alone to pay. However, when you sell an index fund, you are redeeming it from the fund manager, who has to sell securities to raise the cash to pay you. If this is a profitable trade, the net gains are passed on to every investor with shares in the fund. This implies that you can owe capital gains taxes on your index funds without ever selling a single share.

 

Price

The price at which you might buy or sell an index fund isn't the net asset value (NAV) of the underlying securities. No matter when you place your trade, your trade executes at the fund's NAV at the end of the trading day. As such, you cannot really choose an entry or exit price for an index fund because you have no control over the closing price. This contrasts with ETFs where you can determine your entry and exit points because you are trading real-time during the market’s session

 

When are ETFs good for you?

If you are a trader with a short-term investment target, then ETFs can be a good choice for you. This is because they trade like stocks which allow traders to take advantage of market volatility and price movements. ETFs trade intraday, like stocks. This can be an advantage if you're able to take advantage of price movements that occur during the day. If you also have little investable capital, you can invest in ETFs since you can chase fractional shares.

 

When are Index Funds good for you?

Investing in index funds is for those who want to put their money to work and chill. This means you pay no attention to market volatility and price movements. Also, if you have a large lump of cash but are unsure and are risk-averse, then index funds are a good bet for you. If you are investing in major projects such as your child’s education, your retirement, or for a new house, index funds are a good option for you. Since your major target is tracking an index, you just need to look at the historical performance and see if it is the right investment for you.

 

The Bottom Line

When comparing index funds and ETFs, many investors make the mistake of thinking in terms of which is better. The correct approach to this is which one suits my investment purpose. Both of them simplify the decisions an investor has to make by offering a basket of securities lumped into one investable financial product. They are also passive ways to invest, though some ETFs are actively managed.

However, ETFs offer lower expense ratios, greater flexibility, and enable investors to take advantage of short-term market volatility by moving in and out of positions. They are also more tax-efficient and do not require a minimum amount before you can invest in them.

This contrasts to index funds which require minimum amounts and have the possibility for increasing capital gains tax for investors.

An understanding of both assets in view of your investment objective enables you to make the right decisions when it comes to choosing which one to invest in. alternatively, you may choose to invest in both to offer diversification and reduce overall risk to your portfolio.

 

Photo by Robert Anasch on Unsplash

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