If we want to invest passively, we will have to choose between an ETF and an index fund. Even though they have a lot in common, there are certain differences. Here is a comparison between ETF and index funds.
- Two investment options available
- Main differences between Index Funds and ETF
The rise of passive investing has allowed millions of investors around the world to enhance their investment returns. Passive funds have, on average, the same gross returns as active funds. But thanks to their lower fees, their net returns tend to be higher.
Higher net returns have appealed a lot of investors to move their money to passive investment vehicles. Consequently, the popularity of both ETFs, exchange-traded funds, and index funds has grown immensely.
Two investment options available
Let us first talk about the differences between ETF and index funds.
An index fund pools money from many investors, and invests it in such a way that will achieve roughly the same gross performance as a particular index, like the S&P 500.
While similar, an ETF (exchange-traded fund) is listed and trades on a stock exchange, just like a stock. When we invest in an ETF, we buy shares. And we can sell them whenever the exchange is open.
Hence, investing in an ETF is very much like investing in stocks. The difference is that an ETF is a basket of securities, like the 500 stocks in the S&P 500 index.
Main differences between Index Funds and ETF
We will now discuss the main differences between index funds and ETFs. We will see which vehicle is best in that particular category.
1) Invest and withdraw money
The way we invest our money in an index fund and an ETF is very different.
If we want to invest in an index fund, we will transfer a certain amount of money to the company in charge of managing that fund, the fund manager. At the end of the trading day, our money will be added to the fund. The price at which our investment will be made will be the NAV (net asset value), which is simply the fair value of the assets in the fund. And a certain number of units will be given to us. These units work very much like the number of shares in an ETF.
If later on we want to withdraw money, we will notify the fund manager. At the end of the trading day, based on the NAV then and the number of units we owe, a certain amount of cash will be withdrawn from the fund and transferred to us.
As far as ETFs are concerned, they are more flexible. Because they are publicly traded, like a stock, they can be bought and sold throughout the day. As long as the stock exchange is open, of course. That means we can buy and sell at any time, use market order or limit prices, and knowing full well how many shares we are trading.
2) Minimum investment
Both vehicles are generally good when it comes to minimum investment requirements. However, some index funds may have somewhat higher requirements. This makes them accessible to only investors with a considerable amount of capital.
In contrast, there is never a minimum investment amount in ETFs. The minimum is 1 share in the ETF. As a result, the minimum investment is set by the price at which the ETF trades. ETF share prices can range from the low single digits to hundreds of dollars. Though very rarely will we see ETFs trading at higher prices.
3) Management fees
Management fees refer to the percentage of our investment that goes to the fund manager each year. It is a very important aspect, since fees will reduce our net returns. And the difference in net returns between investing with high and low fees can be massive in the long run.
Index funds usually have very moderate fees. Although some index funds have fees as low as those of ETFs, there are still many index funds whose fees range between 0.4% and 1%.
ETFs typically have lower fees, often between 0.1% and 0.5%, depending on the asset class they invest in and the index they track. Even though the difference in fees is not that significant, ETFs do slightly better in this regard.
4) Transaction costs
Because ETFs are traded on an exchange, we will usually have to pay transaction fees when we buy or sell. In addition, we will have to swallow the bid-ask spread. This is the difference between the price at which we buy and the price at which we sell. Generally, we buy at slightly higher prices than when we sell.
On the contrary, there is usually no cost when we want to invest in an index fund or withdraw our money from it. And both investments and disinvestments will take place at the NAV.
Winner: Index funds
If management fees are important to net returns, more so is taxation. Although there are generally very little differences between index funds and ETFs when it comes to taxation, we should highlight a couple of things. Remember, though, that taxes are country-specific, and it is difficult to generalize.
Both index funds and ETFs can be dividend-paying or accumulating. Dividend-paying funds will distribute dividend and interest payments to investors on a regular basis. Accumulating funds will automatically reinvest those proceeds.
Even though there are no differences between index funds and ETFs in this regard, it is important to know the type of fund we invest in. If our fund is dividend-paying, we may have to pay taxes every time we receive cash flow.
The other aspect is that, in certain countries like Spain, tax law allows investors to move money from one index fund to another without triggering any tax event. This means that even if we have achieved capital gains, moving money from one fund to another is not considered selling. This is positive for long-term investors as it allows us to defer the payment of taxes.
By contrast, the selling of an ETF at a profit will almost always trigger a tax event, even if all we want to do is invest that money in another ETF.
Winner: Draw or index funds
6) Tracking error
An important thing to consider when investing passively is making sure that the performance of the fund truly tracks the index’s performance. The difference between fund and index performance is known as tracking error. Tracking error will almost never be 0, but it is important that it remains low.
Although both index funds and ETFs typically have small tracking errors, ETFs tend to be slightly better. This is because index funds tend to have some cash uninvested to be able to meet redemptions if some investors want to withdraw their funds.
7) Investment options
Finally, we must also address the question of investment options offered by both index funds and ETFs. While both index funds and ETFs are available in multiple asset classes and markets, ETFs dominate this category. It is said ETFs offer 10 times more investment options than index funds.
This is important for two reasons. First, a greater availability of funds allows us to invest in those things we are interested in, even if it is something quite specific, such as Japanese small-cap stocks.
Second, the greater availability of funds means that there are multiple options to track any given market, like the S&P 500. The more funds available, the higher the competition between them, the lower the management fees, and the higher our net return.
Finally, I would like to give you my opinion on index funds and ETFs. But remember this is just my point of view, which is biased by my experience. Evaluate your personal situation and where you live before taking investment decisions.
It is not necessary to have a favorite. You can invest in both index and ETFs, depending on the options available for those things you want to invest int.
The two aspects I would pay attention to most are management fees and taxes. Whenever possible, I would go for the product with the lowest management fees. Higher fees will eat away at our returns.
When it comes to taxes, I would tend to favor accumulating funds, whether index funds or ETFs. This will make it possible for us to control the timing of taxes. Instead of having to pay taxes constantly, we decide when to sell and trigger a capital gain that may lead to taxes.
And, if you live in a jurisdiction that allows investors to move money between index funds without triggering a tax event, I would favor index funds if I wanted to have the flexibility to move my money on a regular basis.
If you want to read more about investing in funds and ETFs, check out this section:
Funds and ETF
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