By Anna Churakova
By Tamta Suladze

ETFs And Index Funds: What’s The Difference?

ETFs And Index Funds

Instead of attempting to outdo the market, a lot of individuals opt to mirror the market by channelling their investments into passively managed funds. 

Over a long time, passive investment instruments—such as ETFs and index funds—have routinely surpassed a large portion of active funds, making them excellent options for the majority of investors. So, what are these funds, and how do they differ?

Key Takeaways

  1. Index funds are mutual funds that invest in a predetermined index of securities in order to replicate that index's performance.

  2. Each share of an ETF represents a fraction of the total value of the fund's underlying assets.

  3. The primary distinction between exchange-traded funds and index funds is when the trades take place.

First, What Are Mutual Funds?

Mutual funds are a kind of pooled investment vehicle in which investors purchase "shares" that entitle them to a portion of the fund's underlying assets. A co-investment fund works the following way: The investment company that established the mutual fund sells shares to investors and invests the received capital in a portfolio of securities. The investment objectives of the fund determine the choice of assets.

 What Are Mutual Funds?

There are two main types of mutual funds, open-ended and close-ended, with differing methods of operation. Open-ended mutual funds may distribute an unlimited number of shares to investors and sell those shares only to other investors via the fund. A share unit's worth is determined entirely by the fund's underlying asset measures. Closed-ended mutual funds, on the other hand, issue a fixed number of shares that may be bought and sold on the stock market. In this case, the bid-ask spread plays a role in determining a share unit's value alongside the underlying parameters of the fund's assets.

Co-investment funds can also be classified into actively managed mutual and passively managed funds. Passive co-investment funds are index funds and ETFs.

Fundamentals of Index Funds

Mutual funds that invest only in a predetermined basket of assets, such as S&P 500 equities, are known as "index funds." These investments try to replicate the performance of market indexes such as the Nifty 50, Nasdaq 100, Sensex, etc. Compared to actively managed funds, index funds often exhibit lower expenditure and commission rates.

Simply put, an index fund is a co-investment fund that uses the passive fund management strategy and tracks the particular market index. This strategy implies that the fund's portfolio comprises the same assets as the duplicated benchmark.

Index Funds

For example, an index fund on the S&P 500 reproduces the dynamics of the American stock market. By purchasing one share of this fund, an investor buys 500 shares included in this broad market index.

Index funds offer a wide range of benefits for investors:

  • Wide diversification - If you invest in index funds, you will not need to select and manage assets independently. By purchasing a fund share, you receive a diversified portfolio, minimum risks and returns comparable to the market.

  • Low-cost ratio - The annual expenses of index funds are significantly lower than those of actively managed funds since there are no costs for fund managers and no expenses associated with the frequent purchase and sale of assets.

  • Low level of portfolio turnover - Low turnover reduces the costs and taxes for the investor. Index funds do not change the portfolio until the underlying index's composition changes, resulting in their portfolio turnover of only 3-5% per year.

Understanding ETFs

An exchange-traded fund is also a type of mutual fund. The ETF's shares can be bought and sold like ordinary stocks on securities markets. 

Simply put, an ETF is a pool of assets (stocks, bonds, commodities), the current value of which is evenly distributed across each fund share.

ETFs are purchased and sold through a broker during the trading day and at current market prices. The price of an ETF depends on the composition of the security assets in the fund's portfolio and supply and demand in the market.

Understanding ETFs

Among the advantages of ETFs, we can name the following:

  • Low entry threshold - ETF shareholders do not have any restrictions on the minimum investment amount. An investor can purchase any amount of an ETF's shares.

  • Low commission - As well as index funds, ETFs are passive management funds, so they have reduced expenditures. Moreover, ETFs have no entry fees or early exit fees.

  • Instant liquidity - ETFs are traded on the stock market and can be purchased or sold during the trading day. 

  • Transparency - The allocation of assets in an ETF's portfolio is published daily and gives investors a clear understanding of the securities they currently own.

The Core Difference

The primary distinction between ETFs and index funds is that ETFs may be bought and sold whenever the market is open, much like stocks. Index funds, on the other hand, have a fixed buy and sale price that applies only at the close of trade each day. Since this difference does not materially affect the investment's long-term worth, it may not be a worry for long-term investors. Still, for intraday traders, ETFs might be a better option.

The required minimal investment amount is an additional discrepancy. Unlike index funds, which often need a larger initial commitment, ETFs typically just require a single share's worth of capital.

The operating expense percentage is another difference. Typically, Index Funds have lower expense ratios compared to ETFs, making them a cost-effective choice for long-term investors. For example, the expense ratio of the Vanguard S&P 500 Index Fund (VFIAX) is 0.04%, while the SPDR S&P 500 ETF Trust (SPY) has an expense ratio of 0.0945%.

The difference in transaction fees and trading commissions is another essential consideration. With ETFs, brokers may charge a flat fee for every trade, potentially impacting returns. Some index funds also have transaction fees, so you must compare the prices before investing.

When you buy an ETF, there is an additional cost called the bid-ask spread you do not have when purchasing an index fund. But, if you are purchasing ETFs that are popular and traded a lot, the cost will typically be very low.

ETFs are also generally more tax-friendly, as they do not require paying capital gains tax on gains realised when selling shares. On the other hand, an index fund must buy and sell assets to trace the benchmark index, causing capital gains taxes to be taken out of the fund portfolio net asset value. Nevertheless, index fund holdings rarely change, making this less significant.

Common Features

Since both are co-investment funds allowing for passive investments, they share many common features. The key characteristics are as follows:

  • Lower costs - Both funds are managed passively. Unlike an actively managed fund, in which a broker selects assets to invest in, funds that adhere to passive management do not need to spend funds on brokers, resulting in lower expenses for the investor.

  • Reliable long-term returns - Passively managed investments follow the movements of the index they are tracking. These indexes have typically shown good results with positive returns in the past. For instance, the average annual profit of the S&P 500 has been about 10% over the past 90 years.

  • Heterogeneous portfolio - If you opt for investing in an index fund or an ETF, you will have a well-diversified portfolio since both fund types are based on market indices rather than a single asset type. 

Final Remarks

If you're looking for a passive income stream that doesn't need you to actively monitor your investments or pay for a fund manager, index funds and ETFs are both viable possibilities. However, before putting money into a fund, you should familiarise yourself with its operation, investment strategy, and fees.

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