Exchange Traded funds or the ETF are low cost and the tax efficient investment funds that are directly traded like stocks, commodities or bonds whereas index funds are very similar to high cost mutual funds and these are always traded through a fund manager to ensure the functioning is not impacted.
Differences Between ETF and Index Funds
An Exchange-traded fund (ETF) is an investment fund operating on the stock exchange holding assets such as stocks, bonds, or commodities. These funds track a specific index and accordingly will design its basket of securities. They offer the benefit due to their low costs, tax-efficiency, and features similar to trading stock.
An index fund, on the other hand, is a mutual fund or an ETF constructed to follow a specific industry or index such as the S&P 500. It may design the portfolio based on the implementation rules such as:
- Tax management
- Tracking minimization of errors
- Large block-trading
- Rules which screen social and sustainable criteria.
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ETF vs Index Funds Infographics
Let us understand some of its key differences between ETF and Index Funds
ETF vs Index Funds Video Explanation
There are some factors which make both funds similar in nature and stated below:
- Both are classified under the heading of ‘indexing’ as it involves making an investment in an underlying benchmark index. The objective is to beat actively managed funds in multiple ways.
- They have low expense ratios compared to actively managed funds.
- Funds are managed professionally and aim to reduce risks through diversification.
- They have a Net Asset Value determined as Total Value of the Underlying assets minus Fees / Total Number of Shares.
Below are some of the ETF and Index Funds Differences:
- An ETF is a fund that will track a stock market index and trade like regular stocks on the exchange, whereas index funds will track the performance of a benchmark index of the market.
- The pricing for an ETF takes place throughout the trading day, but index funds get priced at the closing of the trading day.
- Trading fees for an ETF are high, and the expense ratio ranges from 0.1-0.5%, which is adjusted to the price, whereas index fundsIndex FundsIndex Funds are passive funds that pool investments into selected securities. have no Transaction fee or commission.
- In the Indian market, the minimum investment for an ETFETFAn exchange-traded fund (ETF) is a security that contains many types of securities such as bonds, stocks, commodities, and so on, and that trades on the exchange like a stock, with the price fluctuating many times throughout the day when the exchange-traded fund is bought and sold on the exchange. is Rs.10,000, and index funds require a lump sum payment of Rs.5000 or Rs.500 if the SIP (Systematic Investment Plan) is accepted. This amount of minimum investment will vary as per the country and applicable laws. Investment through SIP is not applicable for ETFs.
- The pricing for an ETF depends on the demand and supply of securities in the market, but pricing for an index fund is as per the NAV (Net Asset Value) of the underlying asset.
- The aspect of flexibility and liquidity is comparatively higher in an ETF as the intra-day pricing enables traders to transact with greater flexibility rather than index funds as the NAV, in this case, is calculated only once a day.
- A trading/brokerage accountsBrokerage AccountsA brokerage account is a taxable investment account in a brokerage company where a person deposits its assets and instructs the company to trade in shares or bonds on their behalf. In addition, the company deducts some brokerage or commission. are essential for the buying and selling of ETFs but no such requirement in the case of an index fund.
- ETF does not involve any entry/exit load, but Brokerage, Management fees, and taxes are charged. Index fund involves Management fees, and exit load is applicable in case of liquidation prior to the stipulated time.
- The application of funds is towards Hedging, Arbitrage, and investment of surplus cash for ETFs but focus for an index fund is the only investment of cash surplus.
- With respect to investment application, ETFs can be used for long-term investment and trading strategies but for index/mutual funds; it is wealth creation over the long term through equity and debt base.
- ETFs may have lower tax liability since the trade occurs between investors and the open market, and the fund manager is not required to sell assets for raising cash requirements and hence less possible to create capital gains liabilities. Capital gains tax gets applicable to the transaction but will not be impacted if the investor is holding onto the shares. Conversely, index funds involve a transaction between the investor and fund manager, and if the investor wants to liquidate their share, trading for the same takes place in the market, giving rise to Capital gains or losses.
- As ETFs are traded directly on the open market, they are generally difficult to be traded. An index fund is always routed through the fund manager, making it relatively easier to buy a genuine buyer or seller and ensure regular functioning.
- An ETF transaction requires a settlement time of 3 days, whereas the index fund requires just a day offering the holders quicker access to liquid cash following a sale.
- Though trading of ETFs reflects the real-time environment of the market, as they are not directly associated with the NAV, they are susceptible to manipulations, which may not be acceptable to risk-averse investors with preference to stable investment. Index funds cannot be sold short and generally offer more stability for conservative investors.
ETF vs Index Funds Table
|BASIS FOR COMPARISON||ETF||INDEX FUNDS|
|Meaning||Fund tracking indexes of a specific exchange.||Fund replicating the performance of a benchmark market index.|
|Base||It will trade like other stocks.||They are like Mutual fundsMutual FundsA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etc|
|Pricing – ETF and Index Funds Differences||Done at the end of the day depending on stock price movement.||Traded on an intra-day basis.|
|Basis for Pricing||Demand and supply of the security/stock in the market||NAV of the underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.|
|Trading Costs||Higher costs||No transaction fee/commission|
|Expense Ratios in ETF and Index Funds||Low||Comparatively high|
|Initial Investment||No minimum investment||It can be a few thousand dollars or purchases in regular investments through SIP.|
|Settlement Time in ETF and Index Funds||Three Days||One Day|
It can be concluded that both Index funds and ETFs have their benefits and drawbacks, but both are handy tools for allowing diversification at low prices. The amount of investment and the risk appetiteRisk AppetiteRisk appetite refers to the amount, rate, or percentage of risk that an individual or organization (as determined by the Board of Directors or management) is willing to accept in exchange for its plan, objectives, and innovation. of the investor are the aspects to which the investment narrows down. Despite being largely similar in nature, they are different and inexperienced investors in the stock market have to study all the aspects before making any choice. A retail investorRetail InvestorA retail investor is a non-professional individual investor who tends to invest a small sum in the equities, bonds, mutual funds, exchange-traded funds, and other baskets of securities. They often take the services of online or traditional brokerage firms or advisors for investment decision-making. shall be attracted towards index funds since they are simpler and cheaper to manage with minimum initial investment options. Institutional investorsInstitutional InvestorsInstitutional investors are entities that pool money from a variety of investors and individuals to create a large sum that is then handed to investment managers who invest it in a variety of assets, shares, and securities. Banks, NBFCs, mutual funds, pension funds, and hedge funds are all examples. can consider an ETF as they offer tax sops and features similar to regular stocks.
ETFs and open-end index funds are similar in many ways; however, they are distinguished in many aspects. It is pivotal to set clear goals of investments for the effective selection of suitable investments. For instance, if one requires the flexibility of real-time pricing or the tax advantagesTax AdvantagesTax Advantage are the types of investments or saving plans that benefit tax exemption, deferred tax, and other tax benefits. Examples include Government bonds, Annuities, Retirement Plans. of long-term shareholding, ETFs could be a good fit.
On the other hand, ETFs are more exposed to market volatility, which may be unattractive towards the traditional and conservative investors, or if one wants to earn regular income without dealing with short-term price fluctuations. Although some bond-focused ETFs exist, index funds may be a better choice if investors are looking for exposure to illiquid asset classes such as municipal and international bondsInternational BondsInternational Bonds are debt instruments issued by a non-domestic firm to raise capital from foreign investors & they are usually denominated in the issuing country’s currency. These Bonds have the primary goal to attract more-&-more investors on a massive scale. . In the end, personal preference comes down to the need for liquidity, the disposable income for investment, maturity time, and preference of the asset classAsset ClassAssets are classified into various classes based on their type, purpose, or the basis of return or markets. Fixed assets, equity (equity investments, equity-linked savings schemes), real estate, commodities (gold, silver, bronze), cash and cash equivalents, derivatives (equity, bonds, debt), and alternative investments such as hedge funds and bitcoins are examples..
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