Investing is a preferred method for passive income. Although it has its risks, growing wealth using stock markets gives more returns than any other form. Before going into investing, it is essential to know the different kinds of investment opportunities. Two methods of investing are ETFs (exchange trade funds) and index funds.
This article explores the two different methods and explains the differences between them.
ETF vs Index Fund
ETF (Exchange-Trade Fund) is an investment fund for a basket of securities. You can invest in a wide variety of assets using ETFs. Some assets in ETFs are stocks, bonds, commodities, etc. ETF trading is similar to trading in the stock market. You can buy and sell assets during the designated business hours. You can purchase at varying prices. Whatever the price at the time of the trade will be the trading price. There are different types of ETFs, passive and active ETFs, bond ETFs, industry/sector ETFs, stock ETFs, commodity ETFs, etc. some examples of ETFs are The SPDR Dow Jones, Industrial Average, The SPDR S&P 500, The Invesco QQQ, The iShares Russell 2000, etc.
Index funds are a type of mutual fund. It works by replicating a theoretical segment of the market. Even though Index funds offer good diversity for investing, compared to ETFs, it offers fewer selections for investing. It focuses on specific sectors of the market. You can buy and sell index funds only at the end of the business day. In addition, you can buy assets only at the net asset value. Whatever the NAV is at the end of the day, you can purchase at the amount only. Some examples of index funds are the Standard & Poor’s 500 Index (S&P 500), Wilshire 5000 Total Market Index, Bloomberg U.S Aggregate Bond Index, Dow Jones Industrial Average (DJIA), MSCI EAFE Index, Nasdaq Composite Index, etc.
Difference Between ETF and Index Fund in Tabular Form
| Parameters of Comparison | ETF | Index Fund |
| Meaning | A fund containing a collection of investments | An index fund is a type of mutual fund that replicates the theoretical segment of the market |
| Trading time | Investors can buy and sell assets anytime during the business hours | Investors can only make trades at the end of the trading day |
| Flexibility | You can buy and sell assets at the current market price at a particular time of the day | You can buy and sell assets only at the closing price |
| Cost | Comparatively lower than index funds | Cost varies, but is usually higher |
| Requirement of minimum investment | Not required | Required |
| Transparency | Highly transparent | Comparatively less transparency |
| Management of portfolios | You can manage your portfolio passively | You can manage your portfolio passively or actively |
| Price of assets | The price of assets may not be the same as the net asset value | The price of assets is always at the net asset value |
| Tax | Comparatively more tax-efficient | Index funds are tax efficient, but you will have to pay capital gains taxes |
| Investment opportunities | You have the option of choosing from a wide range of investment choices | Specific investment choices |
| Examples | The SPDR Dow Jones, Industrial Average, SPDR S&P 500, Invesco QQQ, The iShares Russell 2000, etc. | Standard & Poor’s 500 Index (S&P 500), Wilshire 5000 Total Market Index, Bloomberg U.S Aggregate Bond Index, Dow Jones Industrial Average (DJIA), MSCI EAFE Index, Nasdaq Composite Index, etc. |
What is ETF?
An ETF or exchange traded fund, is a variety of investment security. It involves trading of stocks, bonds, commodities, etc. The trading of ETFs is similar to trading stocks. The difference is, you can only buy one asset with a stock, while ETFs contain many assets. You can buy thousands of stocks from multiple industries. ETF prices keep changing throughout the day. You can buy and sell assets by day. The assets are easily liquefiable.
Some examples of ETFs are,
- The SPDR Dow Jones Industrial Average
- The SPDR S&P 500
- The Invesco QQQ
- The iShares Russell 2000
Types of ETFs
There are many types of ETFs available to investors. Some are as follows,
Passive and Active ETFs
Passive ETFs aim to replicate the performance of a broader sector. It contains assets, which are representative of other markets.
Active ETFs include trading without targeting an index of securities. The investors employ portfolio managers to oversee the portfolio. The portfolio managers will be in charge of making decisions like which assets to buy and sell.
Bond ETFs
Bond ETFs include government bonds, state bonds, local bonds, and corporate bonds. Investing in bonds allows investors to generate regular income.
Stock ETFs
Stock ETFs refer to trading in stocks related to an industry or sector. Investors have the opportunity to trade in diversified stocks.
Industry ETFs
Industry ETFs contain investing in funds that are specific to a certain industry. Examples are the oil industry (OIH), the financial industry (XLF), biotechnology (BBH), energy (XLE), and real estate investment trusts (IYR).
Commodity ETFs
Commodity ETFs include investing in various commodities. It helps to diversify a portfolio and hence, make it safer. Purchasing commodity ETFs instead of actual commodities is the cheaper option. Examples of commodity ETFs are crude oil (USO), gold (GLD), natural gas (UNG), silver (SLV) etc.
Currency ETFs
The purpose of currency ETFs is t track the performance of one currency against others.
Inverse ETFs
Inverse ETFs include the process of selling a stock in the hopes that the price goes down. When the price of the stock goes down, the investors repurchase the stock.
Leveraged ETFs
Leveraged ETFs exist to return investments in multiples (e.g. 3x or 4x)
Pros of ETF
- Cost-effective: investors can do the trade transaction themselves. The transaction process is simple, one transaction to buy and one to sell. Therefore, ETFs have fewer brokerage fees.
- Diversity: Through ETFs, you can invest in a variety of industries and commodities
- Risk management: The diversity of investment opportunities provides extra safety. It gives a better opportunity for risk management.
- Target industries: ETFs contain the option to invest in varied industries and specific industries. Some ETFs focus on only specific target industries.
Cons of ETF
- Expense: between active ETFs and passive ETFs, active ETFs are comparatively expensive. They charge a higher fee for their management.
- Single industry: There is a type of ETF with a focus on only a single industry. This type of fund limits the diversification of ETFs.
- Liquidity: If there is a lack of liquid funds, it can hinder the transaction process of ETFs.
What is Index Fund?
An index fund replicates a theoretical segment of a market. It is a type of mutual fund. It helps calculate the performance of the market. An index fund functions to passively replicate the holdings and weightings of an index.
Index fund investment is a form of passive investment. Individuals who invest in index funds do so with a long-term goal. The main purpose of this investment is to gain broad market exposure.
Compared to trading ETFs, you cannot buy and sell index funds throughout the day. You can only trade at the end of the business day. In addition, you can only buy and sell the asset at the net asset value (NAV).
Some examples of index funds,
- Standard & Poor’s 500 Index (S&P 500)
- Wilshire 5000 Total Market Index
- Bloomberg U.S Aggregate Bond Index
- Dow Jones Industrial Average (DJIA)
- MSCI EAFE Index
- Nasdaq Composite Index
Characteristics of Index Funds
Index funds have certain unique characteristics,
Liquidity
In financial situations, liquidity is the ease with which one can buy and sell assets. If you have assets that can turn into cash easily without affecting the price, the asset is liquid. On the other hand, if the asset is hard to buy and sell, it is not liquid.
Index funds provide comparatively less liquidity. Investors can buy and sell assets only at the net asset value. Whatever the NAV is at the end of the day, the investors will have to trade at that value.
Trading Volume
Index funds display less trading volume. Investors of index funds usually have long-term goals. They will buy assets during a particular time and hold them for a considerable time. Hence, fewer assets are traded during day-to-day trading.
Expense Ratio
Expense ratios refer to the annual fees for management and operational costs in a fund. Compared to ETFs, index funds have a higher expense ratio. Actively managing index funds are particularly expensive.
However, there exist some index funds that offer low-cost options to investors.
Transaction Fees
All funds require investors to pay a certain amount as transaction fees and commissions. Index funds have the option to purchase directly from the fund provider. In this case, the investor does not have to pay brokerage commissions. However, certain brokerages charge transaction fees from investors for their trading.
Capital Gains Taxes
Investors receive a passive form of income or gains from their funds. Capital gains in index funds are taxable. The investors will have to pay a certain amount from their profits as tax.
Pros of Index Funds
- Diversification: Investing in index funds provides the opportunity for diversification. Buying a diversified set of assets is important to protect yourself from economic changes.
- Cost-effective: index funds have a lower expense ratio.
- Long-term returns: Investors of index funds usually invest with long-term goals. Long-term investing is a good method to gain high returns.
- Passive investment: Index funds are a great investment opportunity for those who do not wish to engage in the process every day. You can invest in your chosen assets at one time and set them for long-term term growth.
- Taxes: index funds offer lower tax issues for investors.
Cons of Index Funds
- Vulnerability: index funds are highly vulnerable to market crashes and economic situations.
- Low flexibility: index funds have comparatively lower flexibility. You can buy assets only at the closing price and at the end of the business day.
- Lack of human touch: index funds require less human involvement.
- Fewer gains: There is a possibility for limited gains from index funds compared to other types of investment choices.
Main Differences Between ETF and Index Fund (in Points)
- A fund containing a basket of securities is an ETF (Exchange trade fund). A type of mutual fund that replicates a sector of the market is an index fund.
- With ETFs, investors can buy and sell assets at any time during the business hours of the day. In index funds, investors can engage in trade only at the end of the business day.
- You can purchase ETFs at varying prices. You can buy index funds only at the net asset value.
- ETFs are more tax-efficient than index funds. With index funds, you may be required to pay capital gains taxes.
- ETFs offer a wide variety of investment opportunities from stocks, bonds, commodities, etc. Index funds only focus on specific investment sectors.
- ETFs have higher liquidity than index funds. You can buy and sell ETFs without affecting the price. However, you can trade index funds at only the net asset value (NAV).
- ETFs have a higher trading volume compared to index funds. The primary goal of ETF investors is not long-term goals. Hence, they trade assets every day according to changing market status. Index funds investors focus on long-term returns. Hence, they do not engage in trade every day; they buy at one time and keep the asset for the future.
- ETFs do not require investors to make a minimum investment. Investors need to have a minimum investment for index funds.
- Some examples of ETFs are the SPDR Dow Jones Industrial Average, The Invesco QQQ, the iShares Russell, etc. Examples of index funds include the Standard & Poor’s 500 Index, Wilshire 500, Bloomberg U.S Aggregate Bond Index, etc.
Conclusion
To sum up, exchange-trade funds (ETFs) and index funds are means of investment. ETFs offer a wider variety of securities for investment. It allows for all-day trading and trading at varying prices. Index funds focus on a specific sector. You can invest in assets only at the end of the business day and at the net asset value.
References
- https://testbook.com/key-differences/difference-between-etf-and-index-fund