ETFs vs index funds

Once you’ve decided to start investing, there are some choices you need to make, such as between an active and a passive fund. If you chose a passive fund, then you can choose between exchange-traded funds (ETFs) and index funds, but what’s the difference?

In practice, they have a lot in common. They both track an index as closely as possible at a lower cost and bypass the use of an investment manager to pick stocks. However, there are differences in the way they operate that may impact your choice.

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What’s an ETF?

ETFs are collections of investments that have been collected together to try and reflect the performance of an index. Think of it like an Indian-ready meal from the supermarket that you throw in the microwave. It’s not the same as your Indian takeaway, but it’s a decent substitute, is accessible and comes at a lower cost.

ETFs are generally cheap and liquid (meaning they can be bought and sold easily). They’re available on a vast range of indices, commodities and other asset classes.

All passive funds are low cost, but the largest equity indices ETFs, such as the S&P 500 and MSCI World, are available to investors for an annual fee of less than 0.1%. As the funds have got larger, fees have tended to get cheaper.

ETFs generally have a broader range of investment options than index funds, incorporating currencies, commodities and interest rates. They can also incorporate leverage and it is possible to buy “short” ETFs, where investors can benefit from the falling price in an index. This makes them popular with traders taking short-term positions in markets or looking for nuanced portfolio positioning.

What are index funds?

Index funds are open-ended. This means that changes can be made at any time. This is different to “closed-ended” funds, where the pool of capital remains the same size. Index funds don’t trade on exchange: the shares are priced daily based on their current net asset value.

This means that the net asset value always reflects the price of the underlying assets, unlike closed-ended funds that may trade at a discount or premium to net asset value.

Index funds are refreshingly straightforward. Investors buy directly from the provider or through an investment platform. You know that you’ll get the performance of the index, less any associated fees. Index funds usually track the market through physical replication, which means they buy all the stocks in the index at their exact weighting in the index. Where this isn’t possible, some providers may use “sampling” to track the index, meaning they buy key stocks whose performance closely resembles that of the index.

ETFs vs index funds: Similarities and differences

What’s the same?

• Track an index or equity. Both ETFs and index funds aim to replicate the performance of an equity or index as closely as possible without the intervention of an investment manager
• Less risk. ETFs and index funds both hold less risk than individual stocks and bonds.
• They track the same indices. ETFs and index funds hold many of the same indices, such as the S&P 500 or the FTSE All-Share.
• Plenty of investment options. Both offer a wide choice of markets and asset classes.
• Costs. Both ETFs and index funds aim to reduce costs for the investor.
• Tax advantages. Both have tax advantages, such as having capital gains roll up within the fund tax-free

What’s different?

• History. Passive funds have been around for much longer than ETFs. Vanguard’s Jack Bogle launched the first passive fund in 1975, while ETFs have only been around since 1993, when State Street launched its first SPDR ETF, also based on the S&P 500.
• Index funds are more widespread. This is despite ETFs having had a bit of momentum in recent years.
• Buying and selling. ETFs are bought and sold on exchange, which means investors get an instant price and make the transaction according to the settlement terms of the exchange. Index funds only trade once a day, and it can take a few days to liquidate a position and settle it.
• Timescales. Due to the way they are traded, index funds tend to suit longer-term investors, whereas ETFs tend to suit those who like to trade more flexibly.
• Minimum investment levels. For index funds, the minimum investment will generally be higher. For ETFs, it may be as little as $50, but it can be $5,000 or more for index funds.

Fees

Broker fees
Because ETFs trade like normal shares, investors need to pay a broker fee each time they make a transaction. Depending on the platform, this can mount up, which can make them a poor choice for regular savers trying to put small amounts to work every month – the dealing costs can end up being a disproportionate amount of the overall investment.

Bid-offer spread
With ETFs, investors also need to factor in the bid-offer spread (the gap between the price at which the broker is prepared to buy and sell). This is usually very small for large, liquid ETFs based on major indices, but can widen out for smaller ETFs.

Annual management fee
For both ETFs and index funds, investors will pay a small annual management fee plus any fee for holding the funds on an investment platform.

The difference in the annual management fee between ETFs and their index fund equivalent is relatively small.

Rebalancing costs
Open-ended funds need to rebalance constantly to adjust for inflows and outflows. This creates some trading costs. This doesn’t happen with ETFs, which have a unique process called creation/redemption in-kind where shares of ETFs are created and redeemed with a like-for-like basket of securities. This means ETFs don’t have these transaction costs.

Cash drag
Open-ended funds need to hold some cash to meet redemptions. This is cash that is not at work in the market and not earning dividends at any given moment. While this may benefit an index fund at times when the market is falling, for the most part, it will exert a small drag effect on returns.

Dividend policy
Index funds reinvest dividends immediately (unless the unitholder is holding income units, in which case they are paid out). The nature of ETFs means that dividends need to be held in cash until the end of the quarter. This can make a difference if dividends are high and shares prices are rising quickly.

ETFs vs index funds: Which is for me?

Neither of these is necessarily better than the other. The right option will depend on you, your circumstances and your investment ambitions. However, it is possible to make some general points:

In summary

In practice, the difference between the returns from an ETF and from an index fund from the same provider is likely to be minimal. Costs and performance are likely to be similar. The real decision is on the type of investor you are and on how the fund will be bought and sold.