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 about how to decide which one to invest in. In this article, I'll be breaking it all down!
Both index funds and ETFs have a lot of benefits, and it's a good idea to make them part of your passive investment strategy.
After reviewing your investment objectives, you may decide that including one or both of these funds is a good idea. So, here they are - the pros and cons of ETFs vs index funds.
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.
They are baskets of securities that try to track a certain benchmark index and make a profit. So rather than investing in individual stocks, you are increasing your chances of success by buying into everything at once.
For example, both investments could track the S&P 500 Index which are the 500 largest publicly-traded companies in the U.S. This means that by purchasing one of these two investments 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 the two.
Similarities between ETFs and index funds
When comparing the pros and cons of index funds vs ETF, they are both similar in that they:
Broad diversification
When it comes to broad diversification in an investment portfolio it doesn't get better than this. Both funds offer broad diversification. You can potentially be invested in hundreds or even thousands of companies. This in turn can help with minimizing risk.
Low fees
They are passively managed which means there isn’t a dedicated fund manager. And as a result of this passive management, you get lower fees 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.
Dividends
An ETF may pay dividends. This could be a good idea for making some money over time. But there are different types of dividends, as explained by J.K. Lasser of Fidelity.
Index funds may pay dividends, as well, so this is another of the pros for both, rather than an ETF vs index fund situation.
The main differences 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 because the minimum initial investment is usually low.
However, more and more funds are eliminating or reducing minimum investment requirements for their index funds so this is no longer a big deal for potential shareholders deciding on index funds vs ETFs.
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. When you are considering the pros and cons of ETFs, know that you can buy and sell ETFs throughout the stock market trading day just like stocks.
But one of the pros and cons of index funds, on the other hand, is they are only available for trading at the end of the trading day at the end of day price. This may be less stressful but you could miss out on opportunities.
For a long-term investor, this difference usually doesn't matter. However, this would matter for someone like a day trader who tracks price fluctuations through the day. And this is because they buy and sell based on those fluctuations.
Liquidity
Timing of trade also ties into another big difference between ETF vs index funds 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.
Tax efficiency
This is another difference between the two. Taxes are triggered when stocks in an investment is 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.
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 - index fund vs ETF. Gathering all the data, it may appear that there aren't many concerns about buying ETFs or index funds.
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.
When figuring out the pros and cons of index funds vs ETF both present great investing options. Another good way to increase your money would be with an IRA or a 401(k) plan from your company.
When to buy index funds and ETFs
It isn't usually wise to try to time the market with investing. Rather, investing participants should put money systematically into either of these options or both. That way your money can grow slowly over time.
Where to buy index funds and ETFs
Now that you know the difference between ETF vs index funds, many financial institutions can help you purchase either. Here are some popular ones:
Vanguard
Vanguard is a trusted household name and a broker for investments. This is a great company to start with and is considered quite safe.
Fidelity
Another good company, Fidelity offers index mutual funds and ETFs. Their index mutual funds offer a zero expense ratio and the ETFs are commission-free.
Compare index funds vs ETFs and choose what's best for you!
While there is a difference between index funds and ETFs, and pros and cons of ETFs and index funds, both are great long-term passive 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!
To find out more about investing, listen to the Clever Girls Know podcast, or read finance books.