As new investors start to get the hang of various investment terms, a question asked often is about the difference between index funds and ETFs (Exchange Traded Funds). The follow-up question is usually around how to decide which one to invest in. In this article, I'll be breaking it all down!
Index fund vs ETF: What to know
First of all both index funds and ETFs are an aggregation of stocks, bonds, and other securities. Both of them track or mimic an underlying index depending on the ETF or index fund.
For example, an ETF or index fund could track the S&P 500 Index which is the 500 largest publicly-traded companies in the U.S. This means that by purchasing an ETF or index fund tracking the S&P 500, you’d also be investing in all 500 companies along with other investors.
So now that we know how they work, let's talk about their similarities and then the difference between index funds and ETFs.
Similarities between ETFs and index funds
They are both similar in that they:
When it comes to broad diversification in an investment portfolio it doesn't get better than this. Both ETFs and index funds offer broad diversification. You can potentially be invested in hundreds or even thousands of companies. This in turn can help with minimizing risk.
They are passively managed which means there isn’t a dedicated fund manager. And as a result of this passive management, fees as much lower than your typical mutual fund. This is really key because over time, as your portfolio grows, fees can eat into a huge chunk of your portfolio.
Great performance long-term
Over the long term, the various stock market indexes have performed well. As a result, passively managed funds, which track these various indices have followed suit. Historically, the average return of the stock market has been between 8% and 12% over the last 100 years.
The main difference between index funds and ETFs
Having said all of that, these investment vehicles do have some differences.
Minimum investment requirements
ETFs have typically had the lowest minimum investment amount requirement. As a result, ETFs make it easier for someone to start investing with a small amount. However, more and more funds are eliminating or reducing minimum investment requirements for their index funds so this is no longer a big deal.
Timing of trade
One big difference between index funds and ETFs is the timing of when the trade happens. This is basically when they can be bought and sold in the stock markets. You can buy and sell ETFs throughout the stock market trading day just like stocks. Index funds on the other hand can only be traded at the end of the day at the end of day price.
For a long-term investor, this difference usually doesn't matter. However, for someone like a day trader who tracks price fluctuations through the day, this would matter. And this is because they buy and sell based on those fluctuations.
Timing of trade also ties into another big difference between index funds and ETFs which is liquidity. Because ETFs are traded throughout the trading day, sale transactions clear faster than index funds which have to wait until the next day. Again as a long-term investor, this liquidity factor is not really a big deal.
Another big difference between index funds and ETFs is tax efficiency. Taxes are triggered when stocks in an investment are redeemed or traded for cash. This is known as a taxable event whether it’s in terms of losses or profits. If there are profits, then taxes need to be paid.
Remember, when you purchase into any one of these funds, you are buying into this aggregation of stocks and bonds, etc along with other investors investing in that same fund.
Both ETFs and index funds are great at tax efficiency in long-term investment portfolios. However, ETFs are known to have better tax efficiency than index funds. This is because if an investor wants to redeem shares from an ETF the shares would be sold to another investor on the stock market as an in-kind transaction. This in-kind transaction does not trigger a taxable event. Hence the name exchanged-traded funds.
However, when an index fund investor wants to redeem shares, the index fund may have to sell some of the stocks within the fund to pay the investor. This then results in a taxable event that is passed on to you, cost-wise, as an investor in that index fund.
Should you buy ETFs or index funds?
Based on what you now know, you may be wondering which is best for you.
If you are an active trader or you prefer to use advanced investing strategies involving margin orders, limit orders, and stop-loss orders, etc, an ETF would be best for you. And this is because timing around trades would really matter to you.
Also if you are trading in a taxable account like a regular brokerage then an ETF might offer better tax efficiency. However, index funds are also very tax-efficient and the difference between the two from a tax efficiency perspective can be negligible depending on how you invest.
While there is a difference between index funds and ETFs, both are great long-term investing strategies. As with all investments, it’s important to make sure you have clear goals and objectives and that you do your research. This will help you make the best decision around which of the two will work best for your investment portfolio!