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ETFs vs index funds: What are the main differences and which is better?

Both exchange-traded funds (ETFs) and index funds are useful investment vehicles for both newbies and seasoned investors. However, there are differences between the two. These differences can make each product more or less suitable for a given investor. In the battle of ETFs vs index funds, it all comes down to what you value most and what your investment goals are.

To help you decide which route might be better for you to take as an individual, in the ETF vs index fund debate, we discuss both vehicles in some depth, tell you what the differences are between them, and highlight their pros and cons. Let’s start with ETFs.

What are ETFs?

An ETF (exchange-traded fund) is a kind of security that follows an asset, whether that asset is a commodity, a sector, or something else that can be bought and sold on a stock exchange, in a similar way to that of a regular stock or share.

It can be formulated to track almost anything – for example, the price of a specific type of commodity or a broad range of different securities. They can even be structured to follow particular investment strategies.

What are index funds?

An index fund is a type of mutual fund. For newcomers to the world of personal finance, a mutual fund is something made up from a collective pool of money invested by lots of investors in various securities, including stocks, bonds, and other assets.

The job of an index fund is to follow a specific market index. A market index is a metric used to track the performance of a basket of individual stocks and shares.

As far as the ETF vs index fund comparison goes, both are excellent ways of investing your money. But what the differences are and how these should affect your choice of vehicle for the long term is what we are about to discuss. But, before we do, let’s kick off by looking at their similarities.

They both facilitate diversification – but in different ways

No one likes to keep all their eggs in one basket – especially investors. Either an ETF or index fund will facilitate diversification, which helps to spread risk. You only need a few ETFs or index funds in your investment portfolio. An ETF structured on the FTSE 100, 250 or 300 or the US S&P500 grants you exposure to the stock exchange’s best-performing companies.

Lower costs

In any debate on EFT vs index fund you have to acknowledge that both cost less in terms of management fees because both are passively managed. Mutuals tend to be actively managed, meaning that a human broker intervenes on behalf of his clients to choose when and where to make trades, resulting in higher costs that get passed on to the client.

Better long-term results

Portfolios that are more passively managed track the ups and downs of the assets they’re following and tend to outperform actively managed portfolios in the long-term. On the other hand, actively managed mutual funds can turn in better results short-term, as fund managers are making decisions based on day-to-day movements.

But it’s unlikely that these judgements will be consistently beneficial in the long term. In addition, there are higher management costs to be taken into account.

The key differences between ETFs and index funds

Let’s now get on with the business of analysing the difference between ETF and index fund and take a look at where the divergences occur.

The difference in diversification

In the index vs ETF investment vehicle debate, it must first be acknowledged that both are trackers of sorts. The big difference is that while an index fund tracks the performance of many different companies, they all operate within a specific sector.

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However, ETF’s can put together with a diverse range of assets, examples being gold or real estate or renewable energies, all together in one “basket” or portfolio.

In answering the question of what’s the difference between an index fund and an ETF it must first be appreciated that both funds are considered more budget-friendly than mutual funds. But because of their inherent passive management style, index funds can still have higher management fees than ETFs. However, you usually don’t have to pay transaction costs or commission when trading with index funds.

How they are bought and sold

The way that ETFs vs index funds are traded is significantly different. You can trade ETFs at any time of the day – the same as stocks. On the other hand, index funds can only be traded at the close of the business day.

To be honest, if you are a long-term investor, this trading disparity shouldn’t make a huge difference. But if you are into reactionary intraday trading, then ETFs are the route to go down. You can trade ETFs like stocks and still get the potential safety of diversification. It’s a win, win.

Investment cost minimums

ETFs very often enjoy lower minimum investment sums index funds. In most instances, the price of purchasing one share is enough to start an ETF. Some brokers will even set you up with fractional share ETFs, something that is particularly useful to newbie investors. But, it’s not the same with index funds.

The majority of brokers often insist on putting minimum investment sums in place that are significantly higher than typical share prices. Minimum investment sums of anywhere from £500 to £2,000 are quite normal. However, if you search around, you can find some brokers online who do not impose minimums on initial investments.

In the ETFs vs index funds debate, both are viewed as being better than mutual funds in terms of budget-friendliness because both are passively managed. But a traditional index funds vs ETF comparison shows that Index funds often have bigger management fees even though you don’t normally have to pay commission or transaction fees.

Using robo advisors to lower costs

Some people worry about ETFs and the fact that they carry commissions and fees, as they trade more like stocks throughout the day. While that may be true, that is something that can be offset through the use of Robo-advisors.

Robo advisors often do not charge any commission, their transaction fees are low or even non-existent, and they don’t stipulate investment minimums. Taking each of these things into account,  when looking to a  index fund or ETF for long term investment, they can contribute significantly in terms of minimising your costs.

Which to choose – an ETF or an index fund?

Now we’ve reviewed the differences between the two investment vehicles, you will probably appreciate that in the argument of which is better ETF or index fund that there isn’t very much to choose between them. Both will serve you well. But when push comes to shove in terms of deciding which one to go with, the choice is very much down to the individual investor.

It’s all about what you see your investment goals as being – what sort of risk you feel comfortable with, and what your personal financial situation is.

For many people comparing EFTs vs index funds, it is that extra bit of diversification freedom that comes with ETFs that is the key. Rather than being tied down to one market sector as you are with Index Funds, you can spread that risk over serval industries, commodities etc.

You also have the cost differential, which, in the EFT vs index fund debate, also comes down in favour of ETFs, and while it’s not a huge consideration, when you’re searching for pros and cons, it does figure in the pro column.

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