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 a 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 minimisation of errors
- Large block-trading
- Rules which screen social and sustainable criteria’s.
In this article, we look at the key differences between ETF vs Index Funds –
- ETF vs Index Funds Infographics
- ETF and Index Funds – Similarities
- ETF and Index Funds Differences
- ETF and Index Funds Comparitive Table
ETF vs Index Funds Infographics
Let us understand some of its key differences between ETF and Index Funds
ETF and Index Funds – Similarities
There are some factors which make both ETF and Index funds similar in nature and stated below:
- Both Index Funds and ETFs are classified under the head 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
ETF and Index Funds Differences
Below are some of the ETF and Index Funds Differences:
- ETF is a fund which 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 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 expense ratio ranges from 0.1-0.5% which is adjusted to the price whereas index funds have no Transaction fee or commission.
- In the Indian market, the minimum investment for an ETF is Rs.10,000 and index funds requires a lumpsum 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 ETF’s.
- 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 ETF as the intra-day pricing enables traders to transact with greater flexibility rather than index funds as the NAV, in this case, is computed only once a day.
- A trading/brokerage account is essential for buying and selling of ETF’s but no such requirement in 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 ETF’s but focus for an index fund is the only investment of cash surplus.
- With respect to investment application, ETF’s can be used for long-term investment and trading strategies but for index/mutual funds it is wealth creation over the longer term through equity and debt base.
- ETF’s 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 ETF’s 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.
- ETF transaction requires settlement time of 3 days whereas index fund requires just a day offering the holders quicker access to liquid cash following a sale.
- Though trading of ETF’s reflect 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 and Index Funds Comparative 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 funds|
|Pricing – ETF and Index Funds Differences||Done at the end of the day depending on stock price movement||Traded on intra-day basis.|
|Basis for Pricing||Demand and supply of the security/stock in the market||NAV of the underlying asset|
|Trading Costs||Higher costs||No transaction fee/commission|
|Expense Ratios in ETF and Index Funds||Low||Comparatively high|
|Initial Investment||No minimum investment||Can be a few thousand dollars or purchases in regular investments through SIP.|
|Settlement Time in ETF vs Index Funds||Three Days||One Day|
It can be concluded that both Index funds and ETF’s have its benefits and drawbacks but both are handy tools for allowing diversification at low prices. The amount of investment and the risk appetite of the investor are the aspects to which the investment narrows down upon. 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 investor shall be attracted towards index funds since they are simpler and cheaper to manage with minimum initial investment options. Institutional investors can consider 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 distinguished in many aspects. It is pivotal to set clear the goals of investments for effective selection of suitable investment. For instance, if one requires the flexibility of real-time pricing, or the tax advantages 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 traditional and conservative investor, 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 bonds. In the end, personal preference comes down to need for liquidity, the disposable income for investment, maturity time and preference of the asset class.
These were the ETF and Index Funds Differences, similarities, infographics and comparison tables. You may learn more about Funds from these articles below –