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EFT vs. Index Fund: Deciding What’s Best for You

Educating yourself on the basics of investing is crucial to your overall success when trading. Learning about exchange-traded funds and index funds is part of understanding investment basics. These two types of funds share both similarities and differences, so you should be familiar with these when choosing the best option for you. Explore ETFs and index funds, and learn how they can contribute to your portfolio.

  • ETF vs. index fund: ETFs usually have lower minimum investment requirements.
  • An index fund is an ETF or mutual fund that tracks or matches a financial market index.
  • Both ETFs and index funds are solid ways to diversify your portfolio.

What Is an ETF?

ETFs can be used to invest in various industry sectors as well as are compatible with a variety of strategies.

An exchange-traded fund, often referred to as an ETF, is a group of assets traded in a similar manner to securities. You can buy and sell these funds on an open exchange market, and the securities in the fund typically track an underlying index. ETFs can also be used to invest in various industry sectors as well as are compatible with a variety of strategies. ETF shares are traded throughout the day, similar to regular stocks.

An ETF can be made up of several types of assets, such as bonds, commodities, and stocks, or a combination of these assets. Most ETFs come with lower expense ratios and fewer broker commissions than traditional stocks, making them appealing to investors. ETFs are considered marketable securities, so each ETF will have an associated price for easy buying and selling.

The following are a few of the many types of ETFs available that you can buy or sell on an open exchange:

  • Industry ETFs: These track a certain industry like banking or technology.
  • Bond ETFs: These may include various bonds including corporate and government bonds.
  • Commodity ETFs: This type of ETF invests in commodities such as gold.
  • Inverse ETFs: This type of ETF works to earn gains from declining or shorting stocks.
  • Currency ETFs: These are used to invest in foreign currencies.

What Is an Index Fund?

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An index fund is either an ETF or a mutual fund that has a portfolio devised to track or match the parts of a financial market index, like the S&P 500. Many investors use index funds for long-term investing as they typically use a passive investment strategy and come with fewer fees and expenses when compared to actively managed funds. These funds are often considered optimal core portfolio holdings for retirement accounts, such as a 401(k) account or an individual retirement account.

The primary goal of index funds is to match the return and risks of the stock market with the ultimate assumption being that the market will outperform a solo investment.

Index funds consist of either bonds or stocks and are aimed at mimicking the performance and composition of a market index. The primary goal of index funds is to match the return and risks of the stock market with the ultimate assumption being that the market will outperform a solo investment. For this reason, index funds are typically only suitable for investors who want to make long-term investments as opposed to day traders or investors looking for short-term gains.

Similarities Between Index Funds and Exchange-Traded Funds

Are ETFs the same as index funds? Not exactly, but they do share some similarities:

  • Diversification: Both ETFs and index funds are great ways to diversify your portfolio. Even just a few of either type of investment is enough to significantly diversify a portfolio, as both types of investments include several assets bundled together. For example, investing in an ETF that’s based on the S&P 500 Index gives you exposure to several of the largest companies in the United States.
  • Good Long-Term Investments: ETFs and index funds can both provide strong long-term returns and can be used as a supplement to a retirement account.
  • Passive Management: ETFs and index funds are both passively managed. This means that these funds do not require active management in an attempt to beat the market and make quick returns on investment. Instead, each fund is set up to mirror the market index and profit on the index’s performance in the long term.
  • Low Costs: Both index funds and ETFs are investments that are based on an index rather than a larger investing market. As a result, both types of investments are passively managed rather than actively managed. Passively managed investments are often much lower cost than actively managed investments due to the fact that brokers are not regularly actively deciding what to invest in, thus cutting down on expense ratios and broker costs.

Differences Between Exchange-Traded Funds and Index Funds

If you’re a more active trader and are interested in intraday trading, investing in ETFs is likely the best option.

The following are the most significant differences investors should be aware of when choosing between an ETF and an index fund:

Trading Process

ETFs are investments that can be traded during the day like ordinary stocks. On the other hand, index funds can only be bought and sold for the set price at the end of each trading day. This is not a huge concern for long-term investors; however, if you’re a more active trader and are interested in intraday trading, investing in ETFs is likely the best option.

Capital Gains Taxes

ETFs are considered to be much more tax efficient when compared to index funds due to how ETFs are structured. The process of selling an ETF typically involves selling directly to another investor, meaning that the money gained from the sale is coming from that investor rather than through fund managers and brokers. Thus, capital gain taxes on ETFs are only on that sale and are yours to pay.

On the other hand, index funds require investors to redeem them for cash from the fund manager. The fund manager then must sell the securities to make the cash to give to you. The net gains are passed on to all investors with shares in the index fund, so you could end up owing capital gain taxes even if you personally don’t sell any shares.

Investment Requirements

ETFs typically have lower minimum investment requirements compared to index funds. Typically, all that’s needed to invest in an ETF is the sum needed to purchase a single share. Some brokers will even allow you to invest in an ETF by purchasing fractional shares.

For index funds, brokers put minimum investment requirements in place that can sometimes be much more than what a share in the fund costs. For example, a broker may require a minimum initial investment of $2,000 for an index fund.

Costs

When looking at it from an expense-ratio standpoint, both types of funds are fairly inexpensive to own. For example, a broker’s ETF may have an expense ratio of 0.02%, which means investors will pay just 20 cents per year for every $1,000 they invest in the fund. Expenses to be aware of when choosing which investment to pursue are trading commissions, transaction fees, and bid-ask spreads. Each fund will vary in these expenses. For example, index funds do not require bid-ask spread costs, while ETFs do.

When You Should Invest in ETFs

Here are a few instances in which you should choose to invest in ETFs over index funds:

  • You are currently an active trader or want to begin intraday trading. ETFs allow you to set limit orders and stop-limit orders or utilize margin in your strategies, making it easy to trade ETFs like ordinary stocks throughout the day.
  • You want to invest in a tax-efficient manner. ETFs are typically much more tax efficient than index funds, so if this is especially important to you, ETFs may be the best option.
  • You want to switch brokers eventually. ETFs can be easily transferred between broker firms, unlike index funds, which typically must be closed before switching brokers.

When You Should Invest in Index Funds

Index funds do not require active trading and cannot be traded throughout the day like ordinary stock and ETFs, making this type of investment ideal for more passive traders.

Here are a few reasons why index funds may be a better investment option when compared to ETFs:

  • You have no interest in actively trading. Index funds do not require active trading and cannot be traded throughout the day like ordinary stock and ETFs, making this type of investment ideal for more passive traders.
  • You don’t plan on switching brokers anytime soon. Many brokers require you to close out your index or mutual funds before making a switch, so investing in an index fund is a good option if you plan to stick to the same broker for several years at a time.
  • You want a wider variety. Index funds often provide a larger variety of investment strategies, asset types, and risk tolerance levels when compared to ETFs. While index funds offer the same type of indexed investing options, they also provide an array of actively and passively managed options that can be adjusted to meet your specific investment needs and goals.

There are several benefits of investing in both ETFs and index funds. Essentially, ETFs can be a good way to diversify your portfolio while you learn how to be a more savvy trader. Index funds are useful if you’re strapped for time and want a little more variety in your strategies.