Whether you are just a beginner or an expert in stock market investing, you must hear the terms ETFs (Exchange-traded funds) and index funds, one day or the other. Both are great to start with, but one should critically examine what exactly they are, how do they work? before get in.
Though they are more similar to each other, at the same time, there are few differences as well. Hence it is advised to analyze their similarity, differences, pros, and cons before investing in these investment vehicles.
This article intends to elaborate on the similarity and difference between ETF and index fund based on different critical perspectives which are significant to get the desired outcomes in the future.
Are you not sure of where to invest your hard-earned money? If you often invest, you might know some basics of ETFs and index funds. These are passive investment vehicles, which pool investors’ funds to a batch of securities. This is done to track a particular market index.
Since these pools are passively managed, they are comparatively easier on the pockets as well. These investments will fetch you solid long-term returns, thus promising to be a favorite. If you are seeking long-term investments, you can consider both these options.
While they have similarities, there are major difference between ETF and Index Fund as well.
Table of Contents
ETF (Exchange Traded Funds) –
Exchange-traded funds or ETF is a great product for long-term investment.
You can achieve your investment goals with ETFs. It is generally bought and sold like a company stock while the stock market is open. You can get the intraday price data during the trading session.
ETFs are securities that one can buy or sell via a brokerage firm. It can be transacted like a company stock when the stock exchange is open.
You can get the intraday price data of ETFs during the particular trading day. It is easy to trade, transparent, and has a tax efficiency level.
Index funds – Definition
An index fund is a mutual fund type that tracks the components of a financial market index such as the S&P index. These funds follow the benchmark index irrespective of what the condition of the market is.
Difference between ETF and Index Fund –
Exchange-traded funds (ETFs) and Index funds can be distinguished based on following aspects.
1) Timing for Sale and Purchase –
Exchange-traded funds are bought and sold throughout the trading day just like stocks or other securities, index funds, on the other hand, can be bought and sold at the price fixed at the end of the trading day only.
However, it doesn’t make sense for those who are seeking long-term investment. But if you are interested in intraday trading, ETFs are suitable for such investors, whereas index funds are more convenient for long-term investment.
2) Minimum investment required –
The minimum investment required typically depends on a broker to broker. ETFs require less amount for an initial investment as fractional shares purchase are offered by some companies. On the other hand, in the case of index funds, you need a minimum amount of $2000 or $3000 which may vary from broker to broker.
3) Liquidity –
ETFs are traded on an intraday basis. By means, their liquidity level is quite high. You can buy or sell them anytime when the stock market is open. However, index funds are cleared in bulk when the exchange closes.
4) Taxes over Capital gain –
ETFs are more tax-efficient than index funds owing to their structure. When you are selling an ETF, you are likely to enjoy the capital gains taxes as they are yours. ETFs are better when it comes to capital gain taxes.
Whereas, in the case of index funds, you have to redeem them from the fund managers. They will then sell securities to pay you cash. The net gains are generally passed on to each and every investor with shares in the particular fund. That means you owe capital gains taxes without selling a share.
5) Cost of owning them –
Exchange-traded funds (ETFs) are very affordable, even if you have to pay a commission to brokers while buying or selling them. Index funds, on the other hand, is also cheap to own but they do come with a trading commission.
ETF vs. Index Funds (Comparison Table) –
| Parameter | Exchange-Traded Fund | Index Fund |
|---|---|---|
| Price | Can be traded like stocks throughout the entire day | Can be transacted for the price at the end of the day |
| Minimum investment required | Less as fractional shares are allowed to buy | Expensive as brokers may fix a minimum amount that can be more expensive than the actual share price |
| Liquidity | High | Low |
| Capital gain taxes | ETFs are more tax-efficient than index funds owing to their structure. | Since index funds are redeemed from the fund manager who sells the share to pay cash and the net profit obtained from such sale are distributed to every investor, hence you might owe capital gains taxes without ever selling a single share. Thus index funds are less tax-efficient than ETFs. |
| Cost of owning them | Affordable, but you need to pay commisiion while buying or selling. | Cheap to own as well. Some index funds do come with a trading commission. |
- These investments are great for long-term investors. If you are keen on intraday trading, then ET is undoubtedly the right option for you. You can trade them like stocks. A mutual fund is better for short-term investments. Both types are diversified. Investors can buy and sell throughout the day when opting for ETFs but the same differs when it comes to index funds.
- It is a smart idea to consider both as they offer various kinds of features. They differ from each other but at the same time, are unique and good investment options. ETFs are less risker when compares to stocks as well.
- IF you are purchasing ETF, you have to spend on the bid-ask spread. You do not have to incur the expense when purchasing index funds. If you are opting for a high-volume ETF, then the total amount will lead to almost nothing.
- These are low-cost options when compared with mutual funds. As mentioned earlier, mutual funds are great for short-term investments. They are actively managed. If you are still confused between index funds and ETFs, then you should compare their expense ratio. You also should check the commission you have to bear in each case.
Conclusion –
Wrapping up, there is no either/or question when it comes to choosing any of the two. It depends upon what you prefer. Compare the characteristics and take the right decision.
If you are an active trader, you should go for ETFs. You can impose limit orders on them as well because they are bought and sold like stocks. ETFs are more tax-efficient as well. Index funds are tax-efficient too. You can invest in the latter when you want to invest all the time. Credit in point, index funds always price at the NAV or net asset value.
The expense ratio will also help you make the right decision.
For more investment-related topics, keep an eye on this blog section.
