While it’s clear that buy-the-market style investing is here to stay, financial experts and investors themselves haven’t yet decided which is the better tool for buying the market: index funds or ETFs. The truth is, the similarities between them are much more significant than their differences, but their respective subtleties probably mean you’ll favor one over the other. Let’s compare index funds to ETFs to see which one is right for you.
To begin, we should probably get the confusing nomenclature out of the way. When people say “index funds”, they’re usually referring to indexed mutual funds (that is, mutual funds that track an index vs. being actively managed). And in the context of this article (and many you’ll come across), “ETF” refers to an ETF that tracks an index (a very few ETFs are actively managed, but the vast majority are not). So for the rest of the article, we’ll use the terms index fund and ETF, but understand we’re actually talking about indexed mutual funds and ETFs that track some sort of index.
What Is an Index Fund?
According to Princeton’s online dictionary, an index fund is defined as “a mutual fund that invests in the stocks that are the basis of a well-known stock or bond index”. So, in terms of legal structure, logistics, redemption, and so on, the index fund behaves just like a normal mutual fund. The difference being, a traditional mutual fund is actively managed and statistically under-performs the market (especially when expenses are taken into account), whereas an index fund avoids having a manager actively pick stocks and instead seeks to achieve a particular index’s returns (less expenses, which are typically low compared to those of an actively-managed mutual fund). Many index funds track well-known indices like the S&P 500 or the Wilshire 5000, but there are also index funds that track narrower indices.
What Is an ETF?
According to InvestorWords.com, an ETF is defined as “A fund that tracks an index, but can be traded like a stock”. (Note again, this definition does not apply to actively-managed ETFs, but we can ignore those for now.) So an ETF also tracks an index, rather than employing a manager that actively tries to beat the market. ETFs track all sorts of indices, from well-known ones like the S&P, to much more specialized indices (like hedge fund indices, palladium indices, etc.) Further, an ETF is traded on an exchange like the AMEX or NASDAQ and can be bought and sold just like any other stock.
Similarities Between Index Funds and ETFs
The striking thing when you compare index funds to ETFs is that they are very similar in terms of how they can help long term investors meet their goals.
- Both index funds and ETFs track indices. (They attempt to replicate market returns rather than beat them.)
- Because of the last point, it turns out both index funds and ETFs, on the whole, usually beat the gross returns of their comparable actively-managed counterparts. (Statistically, fund managers buy high and sell low, and meanwhile, transaction costs eat away at returns.)
- Finally, both index funds and ETFs tend to have low expense ratios. (This increases their net returns compared to their comparable actively-managed counterparts.)
So, both ETFs and index funds are great vehicles if you’re trying to implement an investing strategy of “buy and hold the market, and keep expenses low”. It’s a solid, proven strategy, and index funds and ETFs are the typical tools investors use to do it.
Differences Between Index Funds and ETFs
While the similarities between ETFs and index funds are hugely important, they do have some significant differences. These may seem minor (and, if you’re just saving for retirement, they are minor), but they’re worth delineating.
- Index funds can have high minimum investments. (Although, these are often waved if you enroll in an automatic investment program.) ETFs don’t have a minimum investment amount (except the amount that a single share of that ETF costs).
- Index funds are purchased directly from the management company, based on the Net Asset Value at the trading day’s close. You must buy or sell ETFs through a brokerage account, and will pay a “real-time price” based on the bid/ask spread; since you buy them through a brokerage, you will typically incur a flat per-trade fee.
- Some ETFs have lower fees, and tax advantages, when compared to similar index funds. To be clear though, when comparing many ETFs to their equivalent index funds, these differences may be extremely minor or even non-existent.
There are many other minor technical differences between index funds and ETFs — how they are priced, how they trigger capital gains and taxable events, legal structure, availability of certain sectors, and so on. To be honest these may only be worth analysis if you’re really curious or if you are investing a very large sum of money, whereby small differences could have larger absolute effects.
Which One Is Right for You?
ETFs are probably more appropriate for investors who want to actively trade, or who rebalance their portfolios often. Index funds may be more appropriate for investors who are worried that they’ll be “tempted” to actively trade ETFs, since it’s more work to do the same with index funds, and since index funds can’t be traded intra-day.
Warren Buffet recommends index funds: “I have nothing against ETFs, but I really think an index fund that just charges a few basis points for management is pretty hard to beat,” says Mr. Buffett. “You put it away, you have nobody encouraging you to trade it next week or next month… your broker isn’t going to be on you”.
Meanwhile, ETFs have experienced a massive surge in interest and asset inflows in the past few years, so it’s clear many people favor them (and definitely active traders do). Niche, sector, and asset class-specific ETFs have launched to great fanfare in recent years, and there’s no sign of the enthusiasm dying down.
In the end, it’s a matter of investing style, goals, and personal preference. There’s no right or wrong answer: weigh your own strategy and needs and decide which one fits you.