Exchange-traded funds and index funds are both types of funds, as you can probably guess from their names. While they have plenty of similarities, they’re actually very different investment types with different investment strategies. Here are some of the key similarities and differences between ETFs and index funds.
| ETFs | Index funds | |
|---|---|---|
| Listed on a stock exchange? | ||
| Diversification | Medium | Medium |
| Liquidity | Liquid | Liquid |
| Type of fund | Passive | Passive |
| Investment options | Broad – commodities, sectors and indices | Narrow – indices only |
| Priced | Instantly | At the end of the day |
These are simply two different types of fund that are traded slightly differently. Both of them will offer you good diversification and low costs. The main difference is that ETFs are traded on stock exchanges, so they may be more accessible than index funds. You are able to get index ETFs, if you’re interested in tracking a stock market index.
Both index funds and ETFs are liquid, meaning they’re easy to sell, and both are passive, meaning they need little intervention.
If you’re trying to choose between index funds and ETFs, you could always choose both — invest in an index fund that tracks an index that you’re a fan of and an ETF for a sector or country that wouldn’t be widely covered by your index fund. This would give you better diversification.
You’ll encounter fees with most investments — here are some of the fees you’ll come across with index funds and ETFs.
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.
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.
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.
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.
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.
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.
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:
ETFs and index funds are two different types of fund, so both let you invest in a range of investments in one go. Index funds track a specific stock market index, while ETFs have the possibility for broader investment types, and therefore better diversification. 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.
All investing should be regarded as longer term. The value of your investments can go up and down, and you may get back less than you invest. Past performance is no guarantee of future results. If you’re not sure which investments are right for you, please seek out a financial adviser. Capital at risk.
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