Index Fund vs. ETF fund: What are the similarities and differences to know before making a decision?

Index funds and Exchange-traded are vehicles that both new and seasoned investors can choose, but it is better to have a better look between the two, so you can make an informed investment decision.


Regardless of your investor status, whether you are a new or a seasoned investor, you might be looking for new investment opportunities. Investment opportunities that could help you achieve your financial goals are very in demand right now.  And they are positioned to climb new heights of popularity and demand in the coming years as financial education and financial services are becoming more widespread than ever. And so, this is the right time for you to invest in such funds.

Suppose you are not into stocks or bonds or do not have time to invest in individual companies because of your busy schedule or because you do not want to research. In that case, investing in index funds and exchange-traded funds might be a good fit for you.

But if you are thinking of investing in one of the two or on both, you need first to understand what they are so you can make an informed investment decision. Investing is a serious thing that involves risks and opportunities, so you need to have at least a basic comprehension of what you are getting into.


1. What is an index fund?

The term "index fund" refers to the approach taken to a fund. It is a fund with a portfolio designed to track and mimic an index. It is said that index funds provide broad market exposure, low expenses and fees, and low portfolio turnover. It is a passive investment that has limited gain in short spans but is widely successful in the long term. Its limited gains are due to its setup, which automatically mimics the index related to it. It does not try to beat the market, but instead, it tries to match the risk and return of it. So, if the index rises, it will also increase, but in the event that the index experiences a slump, it will also experience a slump.



2. What is an exchange-traded fund?

Like an index fund, an exchange-traded fund is also a kind of fund that follows an index. It is a type of security that follows an index, sector, asset, and other commodities. But the catch is, like a regular stock, it can also be bought and sold on a stock exchange because of its classification as marketable security. An ETF can be set up to track anything from a single commodity's price to a broad and complex group of securities. It can also be structured to follow particular investment strategies. Since it follows an index, ETFs can include many types of investments like bonds, stocks, other forms of securities, or a mixture of those.



3. Things to consider in deciding between ETF and index fund


If you read the above definitions of ETF and index fund, you might still be thinking about where to invest. That is natural since the definitions were relatively short and are just snapshots. But if you are still wondering what to choose between the two, you ought to read some considerations that might help you decide. Honestly, the two share a number of similarities, but they also have specific differences.

Similarities


  • Both ETF and index funds count several similarities. To start, both funds bundle individual securities like stocks, bonds, and others into a single investment. But this similarity is only one of the many reasons why the two became popular and trending in the investing community. Here are some of the reasons that culminated in the skyrocketing popularity of the two:
  • 1. Diversified portfolio. Both ETF and index funds have a diversified portfolio. Both funds provide this portfolio in a simple way. Since both are tracking an index, they both offer broad exposure to stocks and other securities. This setup reduces the risks associated with other investments since there is a decrease in the chance that market swings will heavily affect the portfolio.

  • 2. Strong long-term gains. While it is true that ETFs and Index funds provided limited gains, this is only the case for short timespans. The human element in actively managed mutual funds provides more significant earlier results since they can make decisions based on their expertise and market condition. Still, only very few can sustain this in the long run. In fact, according to the data of SPIVA Scorecard from S&P Dow Jones Indices, for five years (ending in 2019), 80% of large-cap funds posted returns lower than that of S&P 500
  • On the other hand, the two, if seen in long-term considerations, are much more profitable. Passively managed index funds and ETFs tend to outperform actively managed funds for longer timespans.

  • 3. Low fees. Both ETF and index funds are passively managed. Both funds do not have an active manager who manages the fund since the fund is merely tracking and mimicking the benchmark. Since there is no human element in the fund's management, investors of ETFs and index funds do not need to pay a professional fee to a manager, which is the case in an actively managed mutual fund. Though there are indeed some actively managed ETFs, we will be focusing more on the passively managed kind for the sake of comparison. Because of the absence and presence of the human element, there is a different expense ratio average between actively managed and passively managed funds. In 2018, the passively managed fund posted an average annual expense ratio of 0.15%, more than three times lower than the 0.67% average yearly expense ratio for actively managed funds.




Differences

While index funds and exchange-traded funds share many similarities, there are also some noteworthy differences between them.

1. Trading fees. Both ETF and index funds offer a low expense ratio, with index funds providing a lower amount. But they have different fees beyond that. Almost all brokers have eliminated the commission on the trading of stocks and in ETFs as well. Meanwhile, sales commissions for index funds could prove to be more expensive.  However, most online brokers offer commission-free funds. But there is just no way to validate claims that they are entirely free.


Aside from commission, index funds are also subjected to other fees that you also need to consider. Load fees, which is another form of sales commission, are present in index funds. Front-load fees may be imposed on you upon buying funds, while end-load fees for selling it. The amount of these fees can either be a percentage of your total purchase or a flat fee. On the other hand, ETFs do not have load fees.


So, while the expense ratio of ETFs could be higher than that of an index fund, you still need to consider the commissions to which index funds are subjected.


2. The way they are being purchased and sold. ETFs are like regular stocks in terms of buying and selling since they can be traded throughout the day. On the contrary, investors can only buy and sell index funds at a price set at the end of the trading day.

3. Minimum Investment. ETFs have a lower minimum investment compared to index funds. The least amount you need if you are planning on investing in an ETF is the amount required to buy a single share or lower since some brokers offer fractional shares. On the other hand, starting your investment in an index fund might be pricier. Many brokers for their index funds provide a minimum investment with figures that reach thousands of dollars. An example of this is Vanguard which offers most of its index funds at $3000. But it is worthy to note that some online brokers do not have a minimum initial investment requirement.


4. Taxation. Generally, ETFs are more tax-efficient compared to index funds. When you sell an ETF, you are practically selling it to another investor who is willing to buy it, with the cash coming directly from them. Therefore, the capital gains taxes on that sale are yours alone to pay. But the same is not valid in index funds. To withdraw cash from an index fund, you need to get it from the manager, who will sell securities to gain the money you are withdrawing. The capital gains taxes in these sales will be taken out of the fund portfolio, which will impact the value of your shares. This means that you could be charged for capital gains taxes though you are not selling a single percentage of your shares.


4. Bottomline


In the end, the question of where you would invest resides on you alone. But this question is trivial if you are firm on your decision of investing for your long-term financial goals through a passive vehicle. Both funds offer you low fees, a diversified portfolio, and solid long-term gains. But if you still don't have any decision right now, then the following might be good for you:

ETFs may be suitable for you if…

If you want to take advantage of price movements during the day, then ETF might be better suited for you. Since ETFs are traded like intra-day stocks, if you can capture the positive movement of the market and capitalize on that trend, you are positioned to gain more. But these gains are highly dependent on your ability to predict the direction the market will take; thus, in the end, it has an equal share of risks and opportunities.

Index funds may be suitable for you if…

If you are not particular about catching every opportunity the trading day shows, then index funds might work with you better.