ETF vs Index Funds: How Do They Differ?

When it comes to investment basics, one of the most important things to learn is the difference between Exchange Traded Funds (ETFs) and Index Funds (invested via a mutual fund usually). In the simplest terms, ETFs are more flexible than most index funds, making them more convenient in the process. It is also possible to trade ETFs with greater ease than index and traditional mutual funds. They are usually traded in the same way that common stocks are traded on the stock exchange. Investors can also buy ETFs in smaller denominations and without the hurdles associated with index and mutual funds. When investors purchase ETFs, they also avoid the special accounts and documentation that are required for investing in mutual funds. Let’s delve a little more into the world of ETF vs Index Funds and find out more differences.

ETF vs Index Funds: Key Differences

Before we discuss the differences between ETF and Index Funds, let’s go over some key similarities between them.

  • Diversification

You can diversify your portfolio with just a few ETFs or index funds in it. Take the popular index fund based on the S&P 500 for example, it gives you exposure to hundreds of the largest companies on the S&P 500 index. 

  • Low cost

Both index funds and ETFs are managed passively. What that means is that the investments in the fund are based on an index, which happens to be a subset of the investing market as a whole. When this is compared to an actively managed fund like many mutual funds with human brokers actively choosing what to invest in, the expense ratios for the investors end up being higher. While some actively managed ETFs also exist, we won’t be looking at them in our ETF vs Index Funds comparison. We are going to stay with the popular passively managed variety of funds.  In 2018, the average annual expense ratio for passively managed funds was 0.15%, compared with actively managed funds’ average expense ratio of 0.67%.

  • Strong long-term returns

When it comes to long term investing, passively managed index funds always outperform (well, most of the time) actively managed mutual funds. Passively managed investments mirror the ups and downs of the index being tracked by them. All of these indexes have traditionally shown positive returns. Take the popular Standard & Poor 500 (S&P 500) index for example, the total annual return for that index has hovered around 10% for a staggering 90 years. That is some incredible consistency in the long run. 

While actively managed mutual funds might perform better in the short term as a result of the investment decisions made by the fund managers on the basis of current market conditions and their own expertise. However, it’s a little unrealistic to expect active fund managers to consistently make market beating decisions in the long term. On top of that, the higher expense ratios will also contribute to lower returns over the course of time when compared to passively managed funds.

What are Index Funds?

Index funds are representative of the market’s theoretical segment. These funds can consist of large companies, small companies, or companies separated by industry, including other options. Index funds form a passive type of investing that sets rules by which stocks are included, then tracks the stocks without trying to beat them. Legendary investor Warren Buffet is a big fan of index funds and he believes that they are a great tool of investment. In his popular book, The Little Book of Common Sense Investing, Warren Buffet said “A low-cost index fund is the most sensible equity investment for the great majority of investors. By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals.” He went on to add, “If I were going to put money into an index fund in relatively equal amounts over a 20 or 30-year period, I would pick a fund — and I know Vanguard has very low costs. I’m sure there are a whole bunch of others that do. I just haven’t looked at the field. But I would be very careful about the costs involved, because all they’re doing for you is buying that index. I think that the people who buy those index funds, on average, will get better results than the people that buy funds that have higher costs attached to them, because it’s just a matter of math.” 

What are ETFs (Exchange-Traded Funds)?

ETF or Exchange Traded Funds are nothing but a collection/basket of assets that are traded on the stock exchange like securities. These ETFs can be traded (bought/sold) on an open exchange. This differentiates them from index and mutual funds, which are only priced at the day’s end. ETFs can offer many attractive features, but their long-term value depends on how well they fit into any individual portfolio. To evaluate the appropriate fit, investors have to be prepared to look under the hood. ETFs are fundamentally technological tools. They are mechanisms to achieve a certain goal, like phones. Traditional mutual funds were rotary phones. ETFs are smartphones: They do the same thing but are in a better package.

ETF vs Index Funds: Other Differences

  • One of the other key differences between ETFs and index funds is the cost. Usually, index and mutual funds don’t carry any shareholder transaction cost. ETFs usually carry lower taxation and management fees. For passive retail investors, index funds are better than ETFs based on cost comparisons. Passive institutional investors are better off with ETFs in general.
  • Compared to value investing, index fund investing is more of a passive investment strategy. Both of these investments tend to be conservative, long-term strategies. Value investing holds more appeal for persistent and patient investors who have no problem waiting for a bargain to come around. Getting stocks at low prices also leads to an increase in the likelihood of profit generation in the long run. Value investors actively seek undervalued stocks and actively avoid popular stocks in an attempt to beat the market and book a great amount of profit. ETF portfolios will be the inevitable default for investors in the years to come because they are lower cost, more transparent and offer greater liquidity and tax advantages than mutual funds. ETFs aren’t just having a moment. They’re creating a movement.

So that was a brief look at the ETF vs Index Funds battle. We can conclude that both index funds and ETFs are low cost options when compared to actively managed mutual funds. In order to choose between index funds and ETFs, you must start by comparing each fund’s expense ratio. The main reason behind that is the fact that it’s an ongoing cost that you will have to pay for the entire time you have the investment. It’s also important to enquire about the amount of money you’ll pay as commissions while buying or selling the investment. Unless you buy or sell too often, those fees will not be very high. Now that we have discussed all of that on the topic of ETF vs Index Funds, you will hopefully have a clearer insight into the differences and similarities between them.

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