Introduction
ETFs (exchange-traded funds) and index funds are two really popular types of investments. They are well known for the diversification they can bring to a portfolio, and appeal especially to investors who want to take a more passive approach to managing their assets.
Despite having a lot in common, the way ETFs and index funds work, their tax efficiency, and their flexibility all differ in important ways.
If you are considering these two investment options but need a little help deciding between them, keep reading.
ETFs vs. index funds: an overview
Before we take a closer look at the differences between ETFs and index funds, it can help to know another important term from the world of finance: mutual funds.
Mutual funds are a type of fund that collects the resources of multiple people to buy financial assets like stocks, bonds, and others.
Mutual funds can be managed in a passive or active way, depending on the specific strategy for each fund. In any case, the goal is the same: to maximize profits and to minimize risks.
In that context, index funds belong to the bigger category of mutual funds. In simpler words, every index fund is a mutual fund but not every mutual fund is an index fund.
So what exactly is an index fund?
An index fund is a type of mutual fund that is passively managed and tries to replicate the performance of an important index of the market, like the S&P 500 or Nasdaq 100.
ETFs are similar to index funds in that they are also usually managed in a more passive way, and they also try to follow an index. But one big difference between the two is that, unlike index funds, exchange-traded funds are traded on the market like stocks.
That distinction is key to understanding how index funds and ETFs operate on the market.
ETFs vs. index funds: key differences
Since, as their name suggests, ETFs are traded like stocks, you can buy and sell them anytime during the open hours of the stock market. Because of that, they have more liquidity, but they also suffer from price fluctuations throughout the day.
In contrast, index funds can only be negotiated at the end of each trading day. Their price is set based on the fund’s net asset value (NAV).
Another important factor is the costs. ETFs usually have fewer expenses compared to index funds, but they can charge brokerage commissions and bid-ask spreads. Those fees might not look bad at first, but they can add up if you buy and sell often.
Index funds, on the contrary, have higher management fees, but they offer a nice feature: you can keep reinvesting your dividends automatically, without paying extra fees every time you invest. This can be a huge plus if you prefer a more hands-off investment approach.
Taxes are a major factor to consider when building your portfolio and choosing your assets
ETFs are well known for their tax efficiency. This is primarily due to their famous “in-kind” method. Simply put, this means that when an investor wants to sell their ETF shares, the fund doesn’t need to make any cash. Those shares can just be exchanged for other underlying assets. Since no cash or gain was created, this reduces many taxable events.
Index funds do the opposite: they create more taxable events because they usually generate more capital gains with their transactions.
Another key difference is related to flexibility. Since ETFs are traded throughout the day like stocks, experienced investors might prefer them, as they can apply advanced trading techniques and keep a close eye on the market. Contrarily, index funds might be a better choice for investors who do not want the stress of daily trading and prefer a more set-it-and-forget-it style.
Lastly, ETFs can be an excellent option for those who want to focus on specific industries, trends, or sectors. Index funds are more conservative and don’t usually go much further than their broad market indices like the S&P 500.
ETFs vs. index funds: major similarities
Despite their differences, index funds and ETFs have much in common, which is why they are usually paired together when considering portfolio diversification options.
They both bring a somewhat passive strategy, helping new investors navigate uncharted waters with a low barrier of entry. Because they try to mimic the performance of a chosen index instead of outperforming it, the costs (and stress) are kept low.
They are also hugely popular. According to J.P. Morgan, the global ETF market is worth $13 trillion. And according to Bankrate, all seven of the world’s largest mutual funds are index funds.
One great advantage of both is the diversity they bring to the table. With just one single purchase, you can benefit from multiple assets across many industries and sectors. You get all that diversity without having to choose and analyze each asset, which makes them even more accessible to individuals who don’t yet know all the ins and outs of the enormous world of investing.
This chart made by Schwab shows how diversification can be crucial to spreading out risk and reducing the chance of losses:
Index funds and ETFs are especially great for people who are in it for the long run and want to maximize the compounding factor of their money over a long time. Retirement accounts are a perfect example of this.
Last but not least, transparency is a huge bonus of both of these investments. They disclose their holdings frequently, especially ETFs, so investors can have more peace of mind knowing for sure what they own and what’s happening with their wealth.
Table of differences between ETFs and index funds
The table below juxtaposes the significant factors an investor should consider and how they differ between an ETF and an index fund.
ATTRIBUTE | ETFs | Index Funds |
Trading | Can be traded throughout the market day. | Can only be traded at the end of the day through the fund. |
Liquidity | Higher liquidity with instant trades and real-time price updates. | Lower liquidity with a delay in trading and a price based on its net asset value (NAV). |
Pricing | Fluctuates during the day. | Only changes at the end of the day. |
Costs | Usually has lower expense ratio but can charge brokerage fees. | Usually has a higher expense ratio but is less heavy on transaction fees. |
Automation | Doesn’t offer automatic reinvestment of dividends. | Provides the possibility for automatic reinvestments. |
Taxes | Better tax efficiency due to its “in-kind” mechanism. | Inferior tax efficiency because it generates more capital gains. |
Flexibility | With more intraday flexibility, it’s possible to use advanced trading techniques. | Less flexible, limited to the fund options, and doesn't have the opportunity for advanced trading. |
Variety | More options with specific ETFs for some key sectors, trends, or alternative assets. | Fewer niche options, focusing more on traditional benchmarks like S&P 500 or MSCI World. |
Hopefully, the table above gives you some clarity about the key differences between ETFs and index funds. While both have some significant advantages, your choice of instrument will ultimately depend on what you prioritize in your investment journey and what’s more important to your specific financial goals, especially in the long term.
Pros and cons of ETFs vs. index funds
Still on the fence? A pros and cons list can always help! Take a look below at the more critical elements to consider before acquiring your next passive investment.
Pros of ETFs
More control: If you’re a sophisticated investor, you can use all your advanced trading methods, like stop-loss orders and margin trading.
Tax optimization: ETFs will trigger fewer taxable events due to their “in-kind” process, which means they don’t generate capital gains when selling their shares.
Smaller investment barrier: small-scale investors can start with as little as the cost of a single share, with no need to invest large amounts of money initially.
Cons of ETFs
More stress: With more freedom comes more responsibility. Price fluctuations and market volatility can create some anxiety.
Trading commissions: Depending on your brokerage (the company that manages your transactions), you can encounter more fees for each exchange.
Complexity and temptation: Beginners can become overwhelmed by the many options and also suffer from the intraday temptation to sell and buy constantly.
Pros of index funds
Simplicity: Index funds are easier to understand and can be a perfect way for new investors to test the waters.
Automation: With index funds it’s possible to keep reinvesting your dividends automatically, taking advantage of the compound effect with less effort.
Predictability: Since they try to replicate a benchmark index, index funds are somewhat predictable and often perform better than actively managed funds.
With pros like that, it’s no surprise that according to Investopedia, index funds had grown to about half of all U.S. fund assets by 2023.
Cons of index funds
Less flexibility: Index funds might not be the right choice for investors who want to respond fast to the changes of the market.
Less tax efficiency: With the capital gains created by the transactions inside the fund, you’ll likely encounter more tax events, especially in taxable accounts.
More investment upfront: It’s not uncommon for index funds to have higher minimum investments, like $1 000 or similar prices.
ETFs vs. index funds: tax implications
ETFs and index funds are both considered tax-conscious investments. Still some investors may like to know more about the specific details, especially those who are in a higher tax bracket.
It can be frustrating when taxes eat up a lot of your gains, so let’s talk in more depth about the tax implications of these two investments.
When it comes to fewer takes, ETFs win the race. This is largely because of their “in-kind” redemption process, where the fund doesn’t need to sell assets to compensate for the sold shares. Instead, authorized participants can exchange those shares for other securities (not cash). That way the creation of capital gains and taxable events are reduced.
Still a little confused? Check out this explanation below:
The strategy
Let’s say an ETF fund gets a lot of redemptions due to a bad day at the market. What happens then is that those investors don’t get cash for their shares, they get some other assets owned by the fund, such as stocks or bonds.
The benefit
Because the fund didn’t actually sell anything, these kinds of transactions don’t trigger taxable events, like selling assets for cash would. That’s why tax-conscious investors often choose ETFs.
Even though index funds are tax-efficient per se, they are not as good in that aspect as ETFs. The reason is that they do have to generate cash when investors cash out, and if those transactions generate capital gains, they get distributed to all investors in the fund. And then, of course, those distributions get taxed.
This means you’ll possibly deal with more taxable events, even if you didn’t sell anything yourself.
Both investments are good when it comes to tax management, you just have to consider those specific details and how they impact you and your portfolio strategy.
Should you invest in ETFs or index funds?
Both ETFs and index funds can help you achieve your long-term goals and increase your wealth.
However, there are some questions that you should ask yourself before committing to either of them:
QUESTION | ANSWER |
Do you see yourself trading often, maybe daily? | If the answer is yes, maybe ETFs are a better option for you. |
Are you extra worried about your tax losses? | If yes, remember that ETFs have more tax efficiency. |
Do you have a focus on long-term investments, especially with retirement accounts? | If yes, index funds could be the best option. |
Do you want to keep checking the market ups and downs, or do you prefer not worrying too much about it? | ETFs give you more control because of daily trading, but index funds are probably less stressful. |
How much money do you have to invest to start? | You can buy ETFs with the price of a single share, index funds will usually have a higher starting price. |
Are you a beginner or an investor with more experience? | Beginners will probably like the simplicity of index funds, whereas experienced investors might enjoy the flexibility of ETFs more. |
Hopefully, this helps clarify things. Now you’re able to make a conscious decision that works with your finances and your goals.
Summary
ETFs and index funds are both fantastic options that could work for many types of investors with different intentions and needs. As is usually the case with investing, there’s no right or wrong answer, but you do have to be mindful of what kind of investor you are and what your long-term financial goals are.
Both ETFs and index funds give you the chance to add more diversity to your portfolio and lean in on a more passive approach, without the stress of having to purchase each asset on its own. Remember these options on your investment journey, and consider FBS for all your trading needs.
