While exchange-traded funds (ETFs) and index funds are very similar, there are a few notable differences that can help you decide which will work best for you. Index funds are a type of mutual fund that tracks an index, such as the S&P 500. When the index is up, your index fund is up, and vice versa. An ETF can also track an index, as well as a sector, commodity, or other financial instruments. However, ETFs can be traded throughout the day on the stock market like any other stock.
The Funds Are Bought and Sold Differently
The most significant difference between index funds and ETFs is how they are bought and sold. ETFs can be traded throughout the day — and their value can fluctuate throughout the day — while index funds do not have a new value set until the end of the trading day. This difference is largely irrelevant if you are in the long-term investment game. For an investment that you intend to hold for 20 years, being able to buy or sell it during the day probably isn’t a significant factor.
However, if you want to take advantage of the micro-swings throughout the day, ETFs are the only way to go. So, while these are both great options for long-term investment purposes, ETFs grant a bit more flexibility while still being a more stable option in the long run than buying actual stocks.
While trading throughout the day typically makes ETFs more liquid, a low-volume ETF can actually be less liquid than an index fund. Index funds are traded with the fund manager, so you’re all but guaranteed to have a buyer for your shares (although you won’t know the exact price you will procure). ETFs require a buyer, so if you have an ETF that no one is interested in, you’re stuck with your shares until you can find a potential buyer.
Since supply-and-demand is a key factor with ETFs, make sure you research the trading volume for a given ETF. If it’s a low-volume ETF, you may have trouble finding a buyer when you want to sell. Also, an ETF in high demand may trade higher than its net asset value, while one with little interest could trade for less. On the other hand, index funds will always trade at net asset value.
The Funds Have Different Minimum Buy-Ins
As a general rule, ETFs have a lower entry price than index funds. Usually, all you need is enough money to purchase one share of an ETF to invest. Some brokerages will sell fractional shares. Conversely, index funds often have a minimum buy-in of a few thousand dollars or more if you utilize a major brokerage. However, some online brokers don’t have minimums, even for index funds, so those index funds may be an option even if you don’t have much money to invest.
ETFs and Index Funds Are Taxed Differently
ETFs are inherently more tax-friendly than index funds due to their structure. Selling an ETF is typically done directly with another buyer who is supplying the funds. Only the seller will have to pay the capital-gains tax in that situation. However, when you cash out of an index fund, you get the money from the fund manager, who then will sell various securities to acquire the cash they use to pay you. When the sale of those securities is profitable, the net proceeds will be divided between all shareholders. This means you may pay capital-gains taxes even though you don’t sell your shares. While that is not a frequent occurrence in index funds like it is in actively managed mutual funds, it’s still worth considering.
The Funds Have Different Ownership Costs
Typically, each of these financial instruments is relatively inexpensive to own. Expense ratios hover around 0.02% to 0.04%, or 20 to 40 cents per thousand invested. Another cost to consider is the commission paid on trading. Commissions can be in the form of a percentage or a flat fee paid to the brokerage. If you’re frequently trading ETFs, this can eat into your profits. Some index funds charge a per-transaction fee for buying and selling, so it’s essential to evaluate expenses before investing in either one.
There is a bid-ask spread cost when you buy ETFs, which index funds do not have. A bid price is what a buyer would be willing to pay for a security such as an ETF at a specific time, while an ask price is what a seller would be willing to sell for at the same point in time. The difference between the bid price and the ask price is the bid-ask spread, which calculates this cost. Typically, this is a negligible amount, but this spread and the subsequent fee will increase for some ETFs with very low trading volume.
Another possible expense to be wary of when purchasing index funds is a sales load. A sales load is an additional charge, similar to a commission, that a mutual fund may charge investors. A sales load is a compensatory charge that goes to the brokerage or firm handling the fund. Sales loads can be charged when you buy or sell; they can also be charged on both occasions. Sales loads aren’t very common with index funds, but they exist; therefore, they are something to be aware of when considering your investments.
Consult 3D Wealth Advisors for Expert Guidance
Both ETFs and index funds are lower-cost options than most actively managed mutual funds. Index funds typically are better suited for investors who are more risk-averse and do not wish to be actively involved in the investment. For example, investors who are trying to keep things simple and save for retirement will likely choose index funds, relying upon the historical trend that stock values increase over time.
However, ETFs are probably a better choice if you’re a more sophisticated investor who prefers to be hands-on and active in the investment process. The choice ultimately depends on the costs of ownership and the tax implications. Compare the expense ratios and commissions, along with the frequency with which you wish to buy and sell, and do the math to determine the best fit for you. If you’re interested in learning more about index funds and ETFs, reach out to the knowledgeable team at 3D Partners Wealth Advisors. We have the experience to help you make informed decisions regarding investments.