The differences between investment vehicles can be confusing for many investors. For example, exchange-traded funds (ETFs) and index funds (a type of mutual fund) can be a source of confusion largely because many investors think these two vehicles essentially represent the same type of product.
The truth is, the two do have many similarities. However, there are important differences between ETFs and index funds investors should be aware of.
What Are the Differences Between an ETF and an Index Fund?
Whether you’re considering investing in an exchange-traded fund (ETF) or an index fund, it’s important to understand how they work. While these two types of funds have plenty in common, they also have some key differences worth noting.
|Investment minimums||Generally lower investment minimum||Generally higher investment minimum|
|How it’s traded||Intraday||Traded at the end of the trading day|
|Capital gains tax||When you sell||When you sell or when the fund manager buys and sells assets|
|Trading fees||Generally lower cost if bought commission-free||More administrative and operating costs, potential for sales load charge|
One of the first differences you’ll notice between ETFs and index funds is their investment minimums. In most cases, you’ll find the investment minimums for ETFs are lower than those for index funds. Because of these varying minimums, there are distinct considerations when constructing investment strategies using the different vehicles.
One of the reasons for this discrepancy is the way the different funds are purchased. ETFs are purchased as individual shares, just like stocks are. As a result, the investment minimum for any ETF is simply the cost of one share. Index funds, on the other hand, are purchased in dollar increments and can have investment minimums as high as several thousand dollars.
The primary difference between ETFs and index funds is how they trade. Exchange-traded funds, as their name implies, trade intraday like stocks, versus index funds which can only be bought and sold at market close when the fund’s net asset value (NAV) is calculated by the manager.
This translates to greater flexibility and liquidity for ETFs, though for long-term investors this difference isn’t all that concerning.
Capital gains tax
Whether you’re investing in ETFs or index funds, you might find yourself on the hook for capital gains taxes, which is incurred when you sell an asset for more than you bought it. But depending on the type of asset, you may have capital gains tax responsibility when you weren’t expecting it.
The only time you have to worry about paying capital gains taxes on ETFs is when you sell your shares and realize gains. You won’t pay capital gains taxes for simply holding the investment in your portfolio. However, because index funds are traded through a manager, they more frequently may need to sell shares to cover redemptions. Each time a trade generates net capital gains within the fund, those gains are passed along to the fund’s investors. As a result, you could pay capital gains taxes while you still hold the investment.
The good news is that, unlike with active mutual funds, index fund managers don’t have to change the holdings of the fund often. As a result, you still may not be on the hook for capital gains taxes often.
Another difference between ETFs and index funds is their trading costs. It used to be common for brokerage firms to change commissions anytime assets were bought and sold. However, more brokerage firms now offer commission-free trading on stocks and ETFs. As a result, trading costs for ETFs are non-existent for most investors.
However, you can still expect to pay trading fees on your index fund purchases. Some brokers may allow you to buy their own funds for free (for example, Schwab waives the commission when you buy a Schwab fund). However, most brokers will charge a transaction fee when you buy a fund from another company, and some may require this on their own funds.
What do ETFs and Index Funds Have in Common?
We’ve talked about some of the key differences between ETFs and index funds. Now we’ll cover a few things the two types of funds have in common.
Low cost of ownership
While they may have different costs to purchase them, one thing that ETFs and index funds have in common is their low cost of ownership once they’re in your portfolio. Both ETFs and index funds have expense ratios, which is the annual fee investors pay. Actively-managed mutual funds are known for having higher expense ratios since there’s a fund manager actively buying and selling assets. But because they are passively managed, both ETFs and index funds enjoy low costs.
Both ETFs and index funds are attractive investment options because of the diversification they offer. With these types of funds, you can add hundreds — or even thousands — of individual stocks to your portfolio with a single investment. For example, by purchasing an S&P 500 fund, you can immediately gain exposure to 500 of the largest companies in the U.S. stock market. And investing in a total stock market ETF or index fund gives you exposure to thousands of companies.
Both ETFs and index funds are passively managed investments, meaning they avoid the costs of an active manager and seek to track an index. These funds are a stark contrast to the active trading strategy that many investors may seek to try to beat the market or a specific benchmark.
A final similarity between ETFs and index funds — and another reason both are so popular — is their strong long-term returns. Historically, passively managed funds outperform actively managed funds. While the financial industry spends millions of dollars promoting active products that promise to outperform the market, even professional active managers rarely beat their benchmark over the long term.
The differences between ETFs and index funds can be nuanced and somewhat confusing if you’re new to the investment game. If you need help with some of the details, a skilled financial advisor can help you determine the most appropriate investment product depending on your unique circumstances and financial objectives.
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