Instead of investing directly in individual stocks, many investors prefer to go down the route of using a fund. This simplifies the process and passes on all the critical investment decision-making to a professional fund manager. Index Funds and Exchange-Traded Funds (ETFs) are two of the most popular low-cost options. But what are the differences between an index fund vs an ETF? And which is the better investment?

What is an index fund?

Index funds pool together shareholder capital to invest in stocks that belong to a specified index, such as the FTSE 100 or S&P 500. The investment objective is to track and replicate the performance of a benchmark stock market index. And as this is a form of passive investing, the expense ratio on these tracker funds is typically very low.

An index tracker fund can come in the form of an index mutual fund or an index ETF. However, the latter is gaining more popularity amongst investors are they are more easily traded and typically charge lower management fees.

What is an ETF?

Similar to a mutual fund, an exchange-traded fund invests in a basket of financial securities to generate returns on behalf of its shareholders.

An index ETF is arguably the most common and popular amongst index investors. However, there are actually seven different types, each with its advantages, disadvantages, risks, and potential rewards.

• Index ETF – Tracks and replicates the performance of a stock market index such as the Dow Jones Industrial Average.
• Industry ETF – Tracks and replicates the performance of an industry or subsector.
• Bond ETF – Invests in a broad range of debt instruments, including government bonds, corporate bonds, and municipal bonds.
• Commodity ETF – Tracks and replicates the performance of a single or a basket of commodities such as lumber, oil, or gold.
• Currency ETF – Tracks and replicates the performance of specific foreign and domestic foreign currency pairs.
• Inverse ETF – Tracks and replicates the opposite performance of financial assets such as stocks or bonds.
• Leveraged ETF – Tracks the performance of an index, sector, bonds, commodity, or currency using leverage to maximise returns at the cost of taking on additional risk.

Unlike a traditional mutual fund, an ETF is traded on a stock exchange like the London Stock Exchange or New York Stock Exchange. This makes them highly liquid assets that can be bought and sold, just like individual stocks. Typically an Index ETF is a passive fund resulting in a low expense ratio. However, other varieties of ETF are more often a type of actively managed fund resulting in a higher annual management fee.

Index funds vs ETFs: The similarities

An index ETF is a type of index tracker fund. But an index fund is not necessarily an ETF as these can also take the form of an index mutual fund. That said, here are some of the other similarities these investment vehicles share.

• Instant Diversification – Both index funds and ETFs invest shareholder capital across a broad range of financial securities like stocks. This provides ample diversification to an investor’s portfolio within a single transaction.
• Low Cost – While there are exceptions, in most cases, index funds and ETFs are passively managed funds. As such, both charge relatively low management fees, with the latter usually having a lower expense ratio.

Index funds vs ETFs: The differences

Depending on when talking about an index mutual fund or index ETF, there are some notable differences that investors must consider.

• Trade Executions – As ETFs are traded on an exchange, buying or selling shares occurs almost instantly while the stock market is open. However, if an index fund is a type of mutual fund, then these shares are not traded on an exchange. Instead, shares are directly bought from and sold to the fund itself, which occurs only once per day at the end of the trading session.
• Investment Requirements – An index mutual fund can sometimes have a minimum investment requirement. This can raise the barrier to entry for lower net-worth investors with smaller amounts of capital at their disposal. By comparison, an ETF doesn’t have minimum investment requirements. Investors simply need to be able to afford at least one share at the current stock price. Having said that, some brokers have begun offering fractional shares for certain ETFs, reducing the barrier to entry even further.
• Fees – An index mutual fund can sometimes be more expensive if entry and exit fees are being charged. These fees are set to cover the higher administrative and operating expenses of running a mutual fund vs an ETF. That’s why the latter does not charge entry or exit fees, making it often the cheaper option of the two in terms of expense ratios.
• Volatility – Both index funds and ETFs are typically highly liquid instruments. However, because ETFs can be actively traded throughout the trading day as opposed to just once per day, they have a reputation for being more volatile.

The bottom line

Historically the performance of both index funds and an index ETF are very similar, separated only by the differences in fees. Similarly, both types of funds are largely exposed to the same level of risk when tracking an index. Therefore, the decision as to which investment vehicle is better ultimately depends on individual preference.

In the end, investors should base their decisions on their investment time horizon, risk tolerance, and investment objectives. And it may be prudent to speak to a qualified independent financial advisor.

This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.