Difference Between ETF and Index Fund: ETF vs Index Fund

Both exchange-traded funds (ETFs) and index funds are valuable investment vehicles for 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 your investment goals.

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. So 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 personal finance, a mutual fund is 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.

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.

Key similarities between ETFs and index funds

Let’s look at some of the key similarities between ETFs and index funds. 

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. Moreover, 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 S&P500 index grants you exposure to the stock exchange’s best-performing companies.

Lower costs

In any debate on ETF vs index fund, you must acknowledge that both cost less in terms of management fees because both are passively managed. However, mutuals tend to be actively managed. This means 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 short-term results, as fund managers make 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 analyse the difference between ETF and index funds, and 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.

However, ETFs can be put together with a diverse range of assets, such as gold or real estate or renewable energies, in one “basket” or investment portfolio.

In answering the question of what’s the difference between ETF and index fund, you must first appreciate 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 Exchange Traded Funds. 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.

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 individual stocks and still get the potential safety of diversification. It’s a win, win.

Investment cost minimums

ETFs very often enjoy lower minimum investment than some 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, which 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 pretty standard. 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 non-existent, and they don’t stipulate investment minimums. Taking each of these things into account,  when looking to an 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 ETFs vs index funds, that extra bit of diversification freedom that comes with ETFs 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 ETF 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 pros column.

Difference between ETF and mutual fund and index fund

Index funds are a type of mutual fund, while investing in ETFs and mutual funds is a way to diversify your portfolio. There are several differences between ETFs, mutual funds and index funds. We will highlight the key differences.

Trading structure

Investors buy or sell shares of ETFs throughout the day in the stock market. ETFs trade like individual stocks, with price fluctuations occurring throughout the trading day, and the value of the ETF can be higher or lower than the underlying assets in the ETF. Index and mutual funds are bought and sold once a day when the stock market closes. The price of index funds or mutual funds changes once a day, so investors receive the same price, which is based on the net asset value NAV. Also, mutual funds are usually bought and sold directly from the mutual fund company that can be listed on the exchange.

Minimum requirements 

ETFs have no minimum investment requirement, and an investor can buy as little as one share. On the other hand, most index funds and mutual funds have minimum requirements that can run into thousands, and the price of an index fund or mutual fund is not based on the share price. The flat dollar amount of mutual funds is sometimes a barrier for investors looking to buy into mutual funds.

Tax efficiency

ETFs and index funds are more tax-efficient than mutual funds. Investors pay capital gains tax on returns on a fund or ETF; however, taxes are not incurred on ETFs when holding adjustments are made to an ETF portfolio. Also, ETFs may pay fewer capital gains taxes due to lower turnover. On the other hand, a fund manager must buy or sell shares in index funds or mutual funds for portfolio adjustments, which can trigger capital gains tax. The capital gains tax from the sale of securities impacts shareholders and shareholders with an unrealised loss on the overall mutual fund investment. Also, ETFs can be placed in retirement accounts such as SIPP for more tax relief, while index funds and mutual funds are the only options for defined contribution pensions.

Management

Most ETFs are passive investing, but a fund manager can actively or passively manage them. Most mutual funds are actively managed, so there may be frequent changes to the underlying assets as fund managers attempt to beat the market by trying to outperform a market index or benchmark. On the other hand, index funds are passively managed because less trading occurs since they try to match the market benchmark.

Trading costs and fees

Lower management costs are associated with ETFs as they are passively managed. Index funds and ETFs generally have low expense ratios, but ETFs may charge a higher annual expense ratio than index funds. Active mutual funds have a higher expense ratio. There are other charges, such as bid/ask spread and trading commission fees for ETFs, as an investor needs to have a brokerage account. Broker’s sales commission fees are associated with index funds. Mutual funds have no brokerage fee, but there are sales loads fees, redemption fees, and operational fees. Also, ETFs can be managed by a robo-advisor while mutual funds and index funds are not.

Lock-in Period

ETFs and index funds have no lock-in period as investors can buy and sell ETFs or equity funds at their convenience. However, close-ended and ELSS mutual funds have a minimum lock-in period, and a penalty fee is charged if shares are sold before the maturity date.