If you are an investor, the question; ETF vs Index fund: which is better for you, will not come as a surprise.
This is because investors are constantly comparing investment vehicles to find the alternative that will help them reach their investment goals quickest.
If you have been thinking about this question, this article will assist you to decide on which to invest in.
Let hit the road!
What is an ETF?
Exchange-traded funds are a type of security that tracks the performance of an index, or some asset class, and it can be bought or sold for a price on a stock exchange just like other securities sold on the stock exchange.
ETFs can be designed to track the performance or value of any asset class you can think of, from stocks to cryptocurrencies, commodities, etc. They can even be designed to track the performance of an investment strategy
Exchange-Traded Funds can also be structured to contain a mixture of investments such as bonds, stocks, commodities, etc. They can also be designed to track the performance of a mixture of investment types.
A popular example of ETFs is the SPDR S&P 500 (SPY), which tracks the performance of the S&P 500 index.
How do ETFs Work?
The exchange-traded fund provider owns the underlying assets and then structures a fund to track the performance of this underlying asset. He then sells the shares of this fund to investors via the stock exchange.
Investors who buy this ETF, only own some portion of the ETF. They do not own any percentage of the underlying asset which the ETF tracks.
Types of ETF
There are several types of ETFs available in the stock market for investors to take advantage of. We will be reviewing them in this section.
As you may have guessed, bond ETFs are ETFs that track the performance of a specific Bond or a collection of them. The income distribution of this ETF depends on the performance of the underlying bonds.
Unlike bonds, ETFs that track bonds do not have a maturity date. These ETFs trade at a premium or discount from the actual price of these bonds.
Examples of bonds that ETFs tracks include government bonds, state and municipal bonds, and corporate bonds.
Stock ETFs refer to a collection of stocks aimed at tracking the performance of an industry or a sector, for instance, the performance of the aviation industry. The goal of stock ETFs is to provide investors with diversified exposure to a particular industry in the economy.
Such collection or basket of stocks may include the stocks of high performers in that industry, as well as that of new entrants with high growth potential.
Stock ETFs attract lower fees and do not include ownership of securities.
Industry / Sector ETFs
As the name suggests, industry ETFs focus on tracking the performance of a particular industry, in an economy. For instance, an aviation industry ETF will include only the stocks of companies operating in the aviation industry, in that economy.
The goal of this type of ETF is to gain exposure to the upside of that industry, by tracking the value of the companies operating in that industry.
Industry ETFs are also known as Sector ETFs.
Commodity ETFs invest in commodities such as gold, oil, etc. as their underlying asset. These ETFs track the value of a commodity, which is their underlying asset.
Investing in commodity ETFs comes with several benefits. Firstly, they help diversify your portfolio, thereby protecting your portfolio from any poor-performing assets you may have.
For instance, commodity ETFs can help protect your portfolio from a downturn in stock prices.
In addition, purchasing Commodity ETF shares is way cheaper than owning the actual commodity. For instance, an ounce of gold sells at over $1500, while an ETF share in gold sells below $200.
Currency ETFs track the performance of currency pairs in the foreign exchange market. This pair could be a local and a foreign currency.
Currency ETFs are purchased for various reasons. An investor may decide to purchase a currency ETF to speculate on the prices of a currency based on the political and economic happenings in a country.
They can also be used to diversify an investment portfolio or to hedge against volatility in the forex market.
You can learn more about currency ETFs by visiting here .
This type of ETF is targeted at getting gains from the decline in the value of its underlying asset. An inverse ETF uses derivatives to short a stock. This is a kind of bet, that the value of that stock would drop.
If the value of the stock decreases, the value of the inverse ETF increases by a proportionate amount.
In the U.S., most ETFs are set up as open-ended funds and are subject to the Investment Company Act of 1940 except where subsequent rules have modified their regulatory requirements. Open-end funds do not limit the number of investors involved in the product.
Advantages of Investing in ETFs
Like all investment vehicles you are familiar with, ETFs have some advantages that make them attractive to several investors. Below are a few of them.
- Access to several stocks across industries
Like you may recall, Industry ETFs give you exposure to the upside of several stocks in an industry. This makes ETF very attractive to investors as they don’t have to buy many shares in the industry to enjoy its upside.
In addition, stock ETFs give you access to the upside of the stock of several companies across several industries.
2. It is cheaper than buying actual stocks or commodities.
Outside ETFs, an average investor would have to buy the shares of a company or buy lots of shares from companies that operate in the industry to enjoy the growth happening generally in the industry.
But with ETFs, an investor is spared all these troubles. All he has to do is buy that industry’s ETF, and viola, he is exposed to the upside of that industry.
Trust me, this is way cheaper!
In addition, commodity ETFs sell at prices lower than the actual amount the commodity it tracks, sells in the market.
3. Cheaper trading costs
Investors execute just one transaction to buy or sell their ETF shares. This is why they pay smaller brokerage commissions since there are only a few trades being executed. Some brokers even offer no commission trading on certain low-cost ETFs.
4. Good Risk Management
ETFs employ diversification of investments as a tool for risk management. For instance, in stock ETFs, the underlying stocks which the ETF tracks are bought across several companies and industries.
So, the poor performance of a particular stock or industry, might not have a major impact on the overall performance of the ETF.
5. Access to the Upside of an industry
Outside ETFs, what other way could an investor enjoy a general boom in a particular industry?
It is hard to think of one!
You can hardly find any means that will help you gain complete exposure to a whole industry.
ETFs, help investors achieve that. That is why it is so popular among investors.
Disadvantages of ETFs
Investing in ETFs is not all rosy. It also comes with a few challenges. Below are a few of such challenges investors are exposed to:
- Actively Managed ETFs attract higher fees
Although your average ETF, has a low transaction fee, the same cannot be said of actively managed ETFs. So, what is an actively managed ETF?
Actively managed ETFs are funds that have a manager or a team managing the underlying asset. This kind of ETF attracts higher fees, because they may have higher chances of better performance.
2. Industry / Sector focused ETFs limit diversification
Although industry ETFs give you exposure to the upside of an industry, they also limit your investments to industry, thereby limiting your ability for further diversification.
And we all know that sometimes, a full industry can experience a huge downturn. In such circumstances, your investment will be at the mercy of the market.
For instance, in 2020, during the Covid-19 lockdown, the prices of oil plunged and all investments in that sector took a beating.
3. Lack of liquidity
Due to the limited number of transactions that happen in an average ETF, there could be a problem with liquidity.
Having discussed ETFs, we will be discussing Index funds in the next section.
What is an Index Fund?
An index fund is a type of mutual fund with a portfolio that is structured to match or track a particular market index.
It comes with a low operating cost, low portfolio turnover, and allows the average investor to get broad exposure to the market it seeks to track.
Index funds do not attempt to beat or earn higher returns than the market or index it seeks to track. Rather, it follows the market, buying all the stocks listed in this index, in order to mirror the general performance of the index.
Index funds have lower fees and expenses than actively managed funds. They follow a passive investment strategy, mimicking the performance of the overall market.
Index funds operate with this theory that in the long term, the market will outperform an investment in any single company stock.
What’s more, investment guru, Warren Buffet recommends investment in index funds for those who wish to invest for the long term, especially for retirement.
According to him, it makes more sense to invest in an index fund, than buying any single company shares. As the index fund will in the long run outperform any single company stock.
A popular example of index funds is the Vanguard index fund.
Benefits of Investing in An Index Fund
- Index funds produce good returns over time
Although individual stocks fluctuate in value, the value of an index fund remains stable. And even in a bear market, individual stocks suffer more losses than index funds.
What’s more, the S&P 500 has posted an average of 10% returns since 1928! This demonstrates how stable and reliable index funds are.
2. Investors pay fewer fees.
Because index funds are passive, and not under the active management of a finance expert or team, investors pay lesser smaller fees. This smaller fee will help the investor maximize their returns on investment.
3. They help diversify investment portfolios.
By their nature, Index funds operate the diversification of investment philosophy. It is a basket of the stocks of several companies in an industry or different companies in a market.
This principle of diversification ensures that the poor performance of a particular stock does not ruin an investor’s portfolio.
4. They have a simple investment strategy
The investment strategy of index funds can be easily understood by any investor. As it simply tracks the performance of a particular index. It does not make empty or complex promises.
ETFs vs Index Funds: Similarities
To find out which will be best for you as an investor, you will have to know their similarities and differences. We will be discussing some of the similarities that index funds share with ETFs.
Both investments operate with the principle of having a diversified portfolio. In addition, they can both can help an investor have a highly diversified portfolio.
2. Low Management Cost
Because ETFs and Index funds are passively managed, they attract a low management cost. Since they simply track the market performance of an index, they do not need to be actively managed after being structured.
3. Great Long term investment strategy
Index funds and ETFs are both great as a long-term investment strategy, as they both offer good returns and outperform individual stocks in the long run.
ETFs vs Index funds: Differences
Although ETFs and Index funds have several similarities, they also have some areas of differences.
These dissimilarities will help you decide which will be more beneficial for you. Let’s review them.
- How they are bought & sold
ETFs are traded all through the day on the stock market, and so like a regular stock, their price fluctuates through the trading day.
However, Index funds can only be bought or sold at the price set at the end of the trading day.
This should not be a major issue for you if you have a long-term investment strategy. However, if you are a trader, ETFs will be best for you, as you can have access to sell or buy ETFs throughout the trading day.
2. Minimum Investment Required
Another place where ETFs differ from Index funds is the minimum amount of money required to invest.
ETFs on average require much less than the minimum amount required by Index fund Managers.
In most cases, ETFs only require the amount it will cost to buy a single ETF share to invest in them. It is not so with Index funds. Index funds often set a specific amount as the minimum required amount to invest in them.
For instance, the Vanguard index fund has a minimum required investment capital of $3,000. T. Rowe Price accepts a minimum of $2,500, to invest in its index fund.
From the above, we can conclude that on average it costs less to invest in ETFs than to invest in Index funds.
Although some online brokers offer index funds with low minimum investment, they are mostly not the big index fund managers you would love to invest in.
3. Capital Gains Taxes
ETFs are more tax-efficient than index funds, because of how they are designed.
For instance, if you sell an ETF to another investor, the capital gains tax on this sale, will be charged to you alone (the seller).
However, when an Index fund is sold and a profit was made because there was an increase in the value of the index fund, the capital gains tax is shared by every investor in that fund.
In effect, in index funds, it is possible to owe capital gains tax even when you have sold nothing.
So, ETFs are more tax-friendly for the average investor, than Index funds.
As the saying goes, different strokes for different folks!
We have tried to review ETFs and Index funds, to provide enough information that will help you decide which will help you achieve your investment goals faster.
Having gained this insight, the next step to take is to compare them against your investment goals. The one that fits best should be the way to go for you.
For instance, if you only have a limited amount to invest, and you wish to invest with a big fundholder, you may need to consider investing in ETFs.
Wishing you all the best, as you make your decision.