ETF vs Index Fund: How To Pick The Right Investment

If you're interested in investing, exchange-traded funds and index funds are great options, but you might want to consider learning more about the two and their differences before choosing where to invest your money.

Investing can be intimidating, especially if you're only starting out. With so many options available, choosing where to invest your money or a company to buy stock from can be quite daunting. So first, let’s define both terms.

What’s an ETF?

An exchange-traded fund (ETF) is a type of fund that can be purchased or sold on an exchange, including a stock exchange. They usually have lower fees compared to other types of funds and have varying levels of risks you can choose from. 

It trades just like a stock and like other types of funds, ETFs pull together money from investors into a basket of different investments such as bonds, stocks, and other securities. By putting the fund's money into different securities, ETFs can provide investors with diversification to help balance risk. Because it's traded on a stock exchange, they're bought and sold just like stocks and usually incur commissions and other fees.

Just like mutual funds, there are also different types of ETFs. Each one comes with different objectives. Some invest in a variety of stocks and bonds while some replicate the performance of a stock index like the Dow Jones Industrial Average or S&P 500.

Different ETFs offer different amounts of diversification. Those that focus on specific sectors typically offer less diversification compared to those built to replicate an index.

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How it works:

The fund provider has the underlying assets, designs a fund to keep track of their performance, and then sells shares in that fund to investors. The shareholders own part of an ETF, but they don’t own the underlying assets in the fund.

Nonetheless, ETF investors that keep track of a stock index may get lump dividend payments, or reinvestments for the stocks that make up the index. ETFs are designed to track the value of an underlying asset or index, but they also trade at market-determined prices that usually differ from that asset.

On top of that, factors such as expenses, longer-term returns for an ETF may vary from those of its underlying asset.

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ETF Pros and Cons

Pros:

• While the majority of mutual funds has a minimum investment requirement, an ETF investor can simply acquire a single share plus any commissions and fees. 
• Most ETFs aren’t actively managed, which means they typically have cheaper management fees than mutual funds.
• Unlike other funds, ETFs are easy to trade.
• Many ETFs are indexed based, which means they're required to publish holdings every day, making them more transparent.
• ETFs are more tax-efficient.

Cons:

• ETFs normally track their underlying index well, but there may be some technical issues that can cause discrepancies
• ETF sales are settled 2 days after a transaction. This means you won't be able to reinvest your funds for 2 days.
• There are some thinly traded ETFs with wide bid or ask spreads. This means you’ll be purchasing at the high price of the spread and selling at the low price of the spread.

What’s an Index Fund?

Index funds are investments made to keep track of the performance of a market index. They include several investments that tend to be diversified in securities across that index.

Index funds include both index exchange-traded funds and index mutual funds. These funds usually use a passive investing strategy. Their goal is to deliver returns similar to an index of investments. However, index funds usually give returns that are slightly lower than an index exchange-traded funds., mainly because of the fees associated with these funds. 

To put it simply, index funds are designed to have a similar performance to that of a major market index. This is why they tend to be diversified in securities across that index and include a number of investments. Index funds can track different assets, including stocks and bonds. There are also index funds that follow commodities, currencies, and other assets.

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Index Fund Pros and Cons

Pros:

• If you’re willing to take a risk, investing in index funds may offer potential benefits such as a lower expense ratio, which is the ongoing cost of investment in the fund compared to actively managed funds.
• Index funds invest across many stocks which makes them diverse. This also means that the value of your portfolio will not be badly impacted should any negative development happen in one of the companies that's part of the index.
• An index fund aims to generate returns as close to its underlying index, so the return potential is likely to be better.

Cons:

• Regardless of which type of asset an index fund tracks, it still has its risks. It means they are exposed to the same risks as the index fund they're following.
• If you invest in an index fund, the investor is signing up for returns that will be in line with the index that the fund is tracking, leaving no room for alpha.

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What do ETFs and index funds have in common?

• ETFs and index funds both bundle individual investments together, including stocks and bonds, into a single investment.
• Both can have a diversified portfolio.
• Index funds and ETFs are passively managed, which means the investments within the fund are based on an index.
• Compared to actively managed mutual funds, passively managed index funds tend to do better. Passively managed investments follow the ups and downs of the index they're keeping track of, and these indexes have shown positive returns in the past.

What are their differences?

• ETFs are bought and sold differently from index funds. ETFs can be traded throughout the day similar to stocks, while index funds can only be bought and sold for the price set at the end of the trading day.
• They have a different required minimum investment. Normally, ETFs will have a lower minimum investment than index funds. Usually, all it takes is the amount needed to buy a single share to invest in ETF. For index funds, brokers often put minimums in place that may be a little higher than the usual price.
• Compared to index funds, ETFs are more tax efficient. When you sell an ETF, you're basically selling to another investor who's purchasing it, and the cash is coming directly from them. The capital gains taxes on that sale are yours alone to pay.

ETF or Index Fund, which one should I invest in?

It's good to take note that ETFs have no minimum investment requirement. This might be a better option for you if you don't have enough money to invest. It's also ideal to choose ETFs if you have plans in buying and selling them more actively, or if you want to invest in a specific market or industry since index funds usually just follow broad market trends without looking at their overall performance.

If you have enough money to meet an index fund's minimum requirement and want a less demanding investment requirement, then you might want to consider index funds instead. You can put your money little by little for your future or retirement and don't worry about it until you finally want to pull your investment.

Apart from ETFs and index funds, one easy way to save for your future plans, first house, or retirement is to join KiwiSaver!

Compare Kiwisaver schemes using CompareBear's FREE comparison tool!