By Iain Butler: Chief Investment Advisor, Motley Fool Canada Fool
At first glance, it can be tough to distinguish exchange-traded funds (ETFs) from index funds. Both offer you a basket of securities (stocks, bonds, commodities, currencies, to name a few). Both passively follow an underlying index market (like the S&P/TSX), rather than a fund manager’s investing strategy. And both enjoy relatively low operating fees.
But beyond these similarities, ETFs and index funds have significant differences. A savvy investor knows the difference between these two investment vehicles and knows which one will help them build long term wealth based on their strategy.
This article will help you understand the differences between ETFs and index funds and determine which one you should be investing in, what are they, and how do you know which fund is right for you?
Let’s take a closer look.
What is an Index Fund?
An index fund is a batch of investments that match or track an index market, such as the S&P/TSX. Keep in mind: Index funds don’t try to beat the market (like a mutual fund does). It simply aims to match the market’s performance.
What is an Exchange-Traded Fund (ETF)?
Like index funds, exchange-traded funds (ETFs) are baskets investments that follow an index market, a certain sector of the economy, or even a foreign market. ETFs trade on an exchange (hence the name), meaning investors can buy or sell them during market hours.
How Are ETFs and Index Funds Similar?
As you can see, ETFs and index funds aren’t radically different. In fact, they have several overlapping benefits, including the following.
Index funds and ETFs expose you to different sectors of the market, helping you invest in a wide array of companies. Once you invest in either fund, you won’t have to worry about rebalancing or managing the fund’s diverse investments: your fund manager ensures the fund is hitting its investment objectives.
2. Better long-term performance
ETFs and index funds are passively managed, meaning they track the ups and downs of a market index, rather than trying to beat it. Over the long-run, tracking an index has historically seen better returns, since it removes the risk of selling for short-term gains at the expense of long-term growth.
3. Lower costs
Because they’re passively managed, ETFs and index funds have lower expense ratios—the annual operating fees for each fund. This is in sharp contrast to mutual funds, whose active management brings more fees and costs.
How Are ETFs and Index Funds Different?
ETFs are the new kid on the block: founded in the early nineties (a decade or so after index funds), ETFs were designed to bring passive investing to a broader audience. They were modelled after index funds (hence the similarities), but with several differences. Here are the most significant ones.
1. ETFs trade like stocks
Perhaps the biggest difference between ETFs and index funds is in ETF’s name—exchange traded. ETFs trade like stocks: intraday. You can buy an ETF in the morning, watch its market price move up in the afternoon, and sell it for a gain after lunch.
An index fund, on the other hand, can’t be bought or sold during normal trade hours. Like a mutual fund, you have to wait until the end of the day to make a trade. That means, if you put in an order to sell your index fund at 7am, you won’t actually sell it until the market closes (usually at 4pm EST).
But there’s a caveat here: just because you can trade an ETF during market hours doesn’t guarantee you’ll find someone to buy it. If no one wants your ETF, well—you’ll have to wait to sell it. Index funds may have less trading flexibility, but they’re traded through a fund manager, which almost guarantees you’ll sell it when you put in your order.
Truthfully—unless you’re a day trader, this difference shouldn’t matter. Long-term investors benefit from the steady growth in an ETF or index fund rather than hopping on short-term gains.
2. Index funds don’t have commissions
An ETF may give you more trading flexibility, but it comes at a cost—commissions. Because you buy an ETF through a brokerage, you’ll pay commission to your broker every time you buy or sell one. Commissions typically aren’t high, but if you trade frequently, they can eat into your investment money.
Index funds, on the other hand, don’t charge commissions, but trading them isn’t always free: you may have to pay a transaction fee for each trade you make, which could be equal to an average commission charge.
3. ETFs (usually) have lower expense ratios
ETFs and index funds are both inexpensive, especially when compared to actively managed mutual funds.
Traditionally, ETFs have enjoyed lower expense ratios—that is, the total operating costs you pay per year, expressed as a percentage. But index funds aren’t that far behind. In fact, lately, the expense ratios on index funds have been very close to ETFs, sometimes too close to even matter.
4. Index funds have more flexible dividend distributions
Everyone likes a good dividend: it means you earned something in your investment. But ETFs and index funds distribute dividends differently, and, in the name of convenience, index funds typically have the upper hand.
Let’s start with index funds. When you get a dividend in an index fund, your fund manager usually reinvests it—free of charge—into more shares. You don’t even have to lift a finger: it’s all done for you.
Not so with an ETF (though some brokers do offer “automatic dividend reinvestment”). Usually, when you get a dividend from an ETF, it sits in your brokerage account. You have to log in, manually buy more shares, and—here’s the killer—pay commissions on the shares you buy. This may be a matter of convenience, sure, but if you forget to reinvest your dividend, well—that’s money that sits uninvested.
5. Index funds may have higher minimums investments
Index fund managers usually require investors to start their fund with a minimum investment, usually a few thousand dollars. If you’re just starting to get your feet wet in the investing world, you may not have a lump sum socked away for investing, which can make index funds feel out of reach.
On the contrary, ETFs don’t have minimum investments, or if they do, they’re typically very low, sometimes as low as a few dollars.
6. Index funds may incur more capital gains taxes
Even though ETFs and index funds are both tax efficient, ETFs have a slight edge over index funds.
To understand why, recall how index funds are bought and sold. Usually, when you sell your index fund, your fund manager has to sell investments within the fund to get the cash to pay you. If this sale results in a gain, every fund holder has to pay a portion of the capital gains tax.
Yes. Everyone. Even if you didn’t sell your share, you still have to pay taxes on someone else’s capital gains.
Unlike index funds, ETFs are traded on the exchange market. That means you can sell it directly to another investor for their cash. If you make money off this transaction, you’ll pay a capital gains tax. But here’s the thing—because your fund manager doesn’t sell investments within the fund to generate cash, no one else pays taxes. It’s a win-win-win (unless you lost money on the sale—then it’s just a loss for you).
Which Is the Safer Long-Term Investment?
The short answer—both ETFs and index funds are equally safe investment vehicles that can strengthen your long-term investing strategy.
If you want the opportunity to trade your basket of investments like a stock, you’ll enjoy the flexibility of an ETF. Just keep in mind day trading isn’t always the best investing strategy, as you could be tempted to grab short-term gains at the expense of long-term growth. And, in addition, you’ll pay commissions for each trade you make.
Alternatively, if you don’t have a lot of money to start investing, an ETF can be a safe and inexpensive gateway to the investing world.
But not all index funds have minimum investments. If you don’t care about day trading, an index fund could be the better investment. An index fund allows you to “set it and forget it,” which is a surefire way to help you build wealth. On the other hand, because of the way index funds are structured, you might pay more capital gains taxes than you would in an ETF (there’s always a drawback, right?).
Beyond these minute (but significant) differences, no matter which one you choose, always know what you’re investing in. Take a good look at the underlying investments in your ETF or index fund. At the end of the day, it’s the performance of these investments that could help you build long-term wealth.
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