It can be hard to decide between an ETF and an index fund. What can be confusing is that they sometimes share the same traits. An ETF can be an index fund, and index fund can be an ETF or a mutual fund.
Typically, the practical comparison will be between an index ETF and an index mutual fund. Either can provide you with a cheap way to hundreds of investments. The best fit will be decided by the kind of trading you’re looking for, the amount of capital you have and if you want automatic investing.
What Is an ETF?
An exchange-traded fund (ETF) is a collection of investments that is traded on a stock exchange. One ETF could have 500 large companies listed in the United States, and one could have bonds or international stocks or companies from a single industry.
The price of ETFs fluctuates during the trading day. The next day, an ETF that sells for $80 in the morning might sell for $79.50 or $81 later in the day.
Some ETFs use an index, others are actively managed. In this case, the ETF follows the S&P 500, which is an index ETF. An active ETF is a type of ETF where the manager makes the investment decisions to achieve a specific goal.
What is an Index Fund?
The objective of an index fund is to replicate a market index. It’s not a description of how the fund is purchased or sold, but rather a description of the investment strategy.
An index fund can be an ETF or a mutual fund. Two funds can both follow the S&P 500, and have essentially the same list of companies. One could trade as an ETF, the other trades as an index mutual fund, the price of which is set once at the end of the day.
That’s why, ETFs vs index funds is not a one or the other proposition! There are actually two types of passive investing that many investors are deciding on.
How Trading Is Different
ETFs are traded throughout the day of the stock exchange. Current price and ordering is available. Index mutual fund orders are settled at the NAV of the fund at the end of the day.
Suppose you invest $1,000. With the price of $50, you might purchase 20 shares of an ETF before fees. If the index fund closed at $25, then the $1000 you invested in the mutual fund would get 40 shares.
While intraday trading offers ETFs greater flexibility, it may not be necessary for long-term investors. The ease of trading can also encourage individuals to take over on each move in the market.
Expense Ratios and Trading Costs
Both structures take an expense ratio – the percentage of fund assets dedicated to operating expenses annually.
An expense ratio of 0.05% costs approximately $5 per year for a $10,000 investment in a fund. If it is at 0.50%, this balance would cost approximately $50 a year. Over the long term, this $45 difference can take a real bite out of compound growth.
Do not presume that all ETFs are less expensive. There are also many index mutual funds that have very low costs. Another factor to consider when investing in ETFs is the bid-ask spread. The five cent difference between the purchase price of $40.05 and the sales price of $40 is a trading cost associated with the ETF.
Minimum Investments and Fractional Shares
Numerous stock brokers are now providing fractional ETF shares. Because ETFs are traded in shares, a $60 investment might result in purchasing 0.25 of a share if the broker has the ability to trade fractions.
Index mutual funds typically are bought by dollar amount and this makes it simple to invest precisely $50 or $100. There is no real minimum for some, but it can be $1,000, $3,000 or higher for others.
Before opening an account, be sure to check on minimums, commissions, account fees, and automatic investment features.
Diversification will be based on the holdings
While both ETFs and index mutual funds can offer diversification, it’s the contents of the fund, rather than its name, that’s the key to diversification.
A wide S&P 500 index fund provides coverage of 500 large U.S. stocks. A total-market fund can include thousands of businesses. The technology sector ETF is much more targeted, comprising just 25 stocks.
If you invested $5000 in one company and the value dropped 60%, how much money would you have?If you invested $5000 in one company and the value fell 60%, how much money would you have? You now have an investment of $2,000. When the same $5,000 is distributed among hundreds of companies, one company failure is not as devastating.
While diversification doesn’t stop a loss from happening, it does minimize the threat of a big loss at one company.
Taxes Can Be Different
ETFs tend to be more tax-efficient than similar mutual funds in a taxable brokerage account. They can be structured to minimize the need to liquidate investments when other shareholders sell, which can help reduce capital gain distributions.
An index mutual fund may pay a capital gain even if you did not sell your shares of the fund. Under local rules, a $200 capital gain distribution from the fund may result in a tax bill.
The variance might not matter as much within a retirement account, which defers or protects investment taxes. Treatment may differ with respect to country and with respect to the account type.
Automatic Investing and Dividends are also options
Index funds have always been a good option when investors want to make regular investments. It’s possible to buy a set $100 each month without having to consider the share price.
Not every broker provides automatic ETF investing and fractional shares. There may also be dividend reinvestment available in both types of funds. The broker has the opportunity to buy additional shares from the fund if the fund pays a dividend of $25.
Reinvestment may help compound growth, but does not mean that dividends will be paid and they may be taxable.
Which Option is Better for Novices?
An Index ETF might be the right choice for you if you need a low minimum purchase amount, day trading, and may want some tax benefits in a taxable account. If you don’t want to deal with order type or market pricing, an index mutual fund may be simpler to use to invest in the same amount monthly.
What if two people invest $200 per month in the same general index fund? One fund has a fee of 0.04% and the other 0.05%. It’s likely that their results will be more dependent upon regular contributions, market returns and being invested rather than the 0.01 percentage-point spread.
How to compare ETFs vs Index Funds
Start with the benchmark. Two funds with the same name could have different indexes and/or companies listed. Check out the investment goal, top holdings, exposure to countries, and industry focus.
Next, take into account the expense ratio, minimum investment, trading fees, bid-ask spread, and tracking difference. The difference tracking is a measure of how closely the fund will track its benchmark after costs.
A low-cost fund is not necessarily a good choice of fund. An inexpensive ETF that targets one specific industry might not offer sufficient portfolio diversification.
The Bottom Line
There’s a misunderstanding about the ETFs vs. index funds debate. An index fund is an investment strategy, and an ETF is a structure of the fund. It typically comes down to an index ETF vs an index mutual fund.
Both are able to provide diversification, exposure to the S&P 500 or other indexes, low fees, and passive investing. ETF’s offer intra-day trading and can offer tax benefits in some accounts. Fixed dollar automatic investing might be easier with index mutual funds.
Select a fund that has appropriate securities, reasonable fees, and attributes that help you stick to your investment plan. The label is typically less important than your ability to stay invested, the time frame, and your savings rate.
Frequently Asked Questions
So what’s the difference between ETFs and index funds?
Not necessarily, as in many cases, ETFs are index funds. An index ETF might provide greater trading flexibility, and an index mutual might provide greater ease in automatic investing.
Is it possible for an ETF to replicate the S&P 500?
Yes. The S&P 500 is tracked by many ETFs that include the stocks that make up the index, but the tracking error and fees may cause returns to vary slightly.
Which has a lower expense ratio, an ETF or an index fund?
One can have the lesser expenses ratio. Don’t assume that one structure is always more expensive than another; compare funds, which follow the same benchmarks.
Discamiler:
The information in this article is intended for informational purposes only and is not designed to offer specific financial, investment, tax or legal advice. Its value may decline, tax laws are subject to change, and its past performance is not indicative of its future performance.
