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ETFs vs. index funds: What’s the difference?
ETFs and Index funds are ideal stepping stones into the stock market for a new investor. They are both more stable and less risky investments than, for instance, cherry picking individual stocks. This page shall describe the differences between ETFs and Index Funds to help you learn which best fits your needs and the balance of your portfolio.
What is an ETF?
An ETF is a bundle of investment securities (i.e. stocks and bonds). Depending on the type of ETF in question, they typically track the performance and yield of a specific index, industry, commodity, or other assets.
You can buy or sell shares in an ETF on the stock market as you would individual stocks. As a result, ETF prices fluctuate throughout the trading day as they are bought and sold on the market.
What is an index fund?
An index fund is a subset of a mutual fund or an ETF. Index funds typically provide broader exposure to the market, have a lower rate of portfolio turnover, and often operate on lower expenses.
Index funds track indexes regardless of the state of the markets. As such, they are typically considered to be ideal stores for retirement accounts (i.e. IRA and 401K).
What’s the difference between ETFs and index funds?
ETFs and index funds are more similar than they are different. After all, index funds can be a subset of an ETF. To bolster your understanding, we have highlighted some of the key differences between ETFs and index funds below.
- Methods of buying and selling. How you buy and sell an ETF as opposed to an index fund is the crucial difference between the two. ETFs, like stocks, can be traded throughout the day. Whereas index funds can only be purchased or sold for the set price at the end of the trading day.
- Initial minimum investment. Typically, ETFs require a smaller minimum investment than index funds because you can buy shares (in some cases, even fractional shares) in ETFs. However, depending on your selected broker for the index fund you are after, there will most likely be a higher minimum initial investment amount required to get your foot through the door. That said, for investors with lower budgets interested in index funds, there are some that do not require any minimum initial investments.
- Cost of ownership. Different brokers charge different commissions for trading ETFs and index funds. If your broker charges a commission, then you will be liable to pay a flat fee every time you buy or sell shares in an ETF. If your broker charges transaction fees for investing in an index fund, you will be liable to pay these every time you buy or sell.
- Capital Gains tax. When you sell a share of your ETF, you are essentially selling it to another investor who is purchasing it, and you pay Capital Gains tax on that sale. Whereas, index funds are less liquid and in order for you to get cash out, the fund manager must sell securities to generate the sale. As this sale will affect every investor in the fund, especially if it is for a gain, you can be liable to pay Capital Gains tax without even selling a share.
Similarities between ETFs and index funds
Despite their nuanced differences, ETFs and index funds share a lot in common. To expand your knowledge, we have outlined some of the key similarities between ETFs and index funds below.
- Affordability. Both ETFs and index funds are comparatively lower cost options for investing in the markets. As both types of investments are usually passively managed, there are typically no management fees when buying or selling shares in either ETFs or index funds. It must be noted however that there are some actively managed ETFs on the market, and you must do your own due diligence when investing on a budget.
- Expense ratios. Both ETFs and index funds are low cost options as compared to other market alternatives but there are expense ratios associated with both types of investments. Albeit usually minimal, expense ratios are an ongoing cost of ownership for both ETFs and index funds. You should review and evaluate an expense ratio before placing your investment.
- Diversification. A combination of even a handful of ETFs and index funds offers you broad and wide-ranging exposure to the market, resulting in a highly diversified portfolio. For instance, an ETF that tracks the performance of the S&P 500 gives you access to some of the world’s largest companies through a single share purchase.
- Long-term returns. Long-term investors will be interested to learn that historically, passively managed funds outperform actively managed funds in the long run. As both ETFs and index funds are predominantly passively managed, you stand to gain a better return on your investment in the long term than you would by investing in an actively managed fund.
Which one is right for me?
If you are an active investor who is interested in intraday trading, then ETFs are the right option for you. You can buy or sell ETF shares (like individual stocks) throughout the trading day. Whereas, you have limited trading ability with index funds as you can only buy or sell shares for a set price at the end of the trading day.
If you are an investor on a budget, then both ETFs and/or index funds with minimal to zero initial investment deposits are the right options for you. You can buy a single and even fractional shares in most ETFs. There are, however, more limited options for investing in index funds that require a small to none initial investment.
There are key differences and wide similarities between ETFs and index funds. Long-term investors who have allocated a budget and timeframe for their investment do not have to evaluate considerations to the same extent. Both ETFs and index funds are investment bundles that are suitable for investing in the long run.
The best places to invest
If you are ready to take the dive and invest in either an ETF or an index fund, the best way to do so requires you to register and set up an account with an online broker. We have selected the top of the market for your ease below.
A quick recap
ETFs and index funds are both bundles of securities that provide broad exposure to the market and diversity for your portfolio. Ideal for long-term investors who can wait for the promise of strong returns in the long run, both passively managed investments tend to be low cost alternatives as compared to actively managed funds.
If you are interested in actively trading and allowing for more flexibility in your portfolio, ETFs are the better option for you. Whereas, if you prefer a more passive and low-frills investment strategy, index funds might be the preferred option for you. Whether you opt for an ETF or an index fund will depend on your individual portfolio goals and you must do your own due diligence to best place your investment.
Fact-checking & references
Our editors fact-check all content to ensure compliance with our strict editorial policy. The information in this article is supported by the following reliable sources.
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