Index funds and ETFs are similar in various ways. Indeed, these funds are among the most similar investment options to each other. Their first similarity is in diversifying the stock portfolio. Note that ETFs can also operate based on indices. Therefore, both funds might aim to purchase shares of companies under a well-known market index. For example, the VTSAX and VTI funds both track the performance of an index, but the former is a mutual fund and the latter is an ETF. Below we will review some of the similarities of these funds.
Comparison of Index Funds and ETFs in Terms of Fees
Active investment methods have numerous fees that must be paid to brokerages at the time of transactions. However, investing in index funds and ETFs incurs low fees because you have fewer financial transactions and your capital is held by the fund over a long period. Therefore, the costs of these two investment methods are close to each other and very low.
Based on a study in 2022, we review the average costs for these two financial instruments:
- Fees for index funds: 0.05 percent
- Fees for ETFs: 0.16 percent
Both are Forms of Passive Investment
If you do not have enough time for active trading methods like day trading of cryptocurrencies or stocks, or if you lack sufficient knowledge in technical and fundamental analysis and working with charts, investing in ETFs and index funds are excellent options for you. In these methods, you only need to make a decision once when choosing the fund. After investing, you won’t have to make any active decisions other than purchasing more units of the index fund or more shares of the ETF or deciding when to sell these assets. Therefore, these two models of investment are also suitable options for beginners.
Another significant advantage of these investment methods is that you can periodically increase the investment amount. For example, if you can do some overtime at your workplace, you can invest the income from it monthly in these funds passively.
Strong Long-Term Performance
Both the index fund and ETF options have strong long-term performance. The reason is that they have a high diversity in their asset composition. Therefore, their performance generally resembles the performance of the index they follow. For example, the famous S&P 500 stock index has had an average annual return of approximately 10 percent over the past 20 years. Thus, if the ETF or index fund follows this index, you can be confident of earning a return close to this amount.
Comparison of Differences between Index Funds and ETFs
While index funds and ETFs have many similarities, they also have several differences. Therefore, investors should be familiar with these differences before choosing between these two options. First, we examine a few differences between these financial tools in the table below and then describe some of them separately.
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Difference in Purchasing Method
There are various ways to purchase an index fund. You can buy units of these funds through a unit provider, an investment company, or an online brokerage. Thus, there is a great diversity in this area for you. However, to purchase an ETF, you must proceed through an online brokerage. Moreover, online brokerages usually offer a wider variety of mutual funds than ETFs.
Let’s review the steps to buy ETF shares through online brokerages:
- Open an account with an online brokerage.
- Evaluate the best investment strategy for ETFs.
- Research available ETFs.
- Purchase ETF shares.
- Decide on an exit strategy.
Comparison of Index Fund and ETF in Terms of Minimum Investment
For index funds, a minimum cost is usually set as the price of one unit of the fund. This amount is typically between $100 and $3000. In the case of ETFs, we deal with units called ETF shares. If you want to purchase one complete share, it might cost a significant amount. However, ETFs also offer another method to address this issue: the sale of fractional shares.
Fractional shares mean dividing each share into much smaller units, sometimes up to one hundred thousandth of a share. In fact, determining which method requires less minimum investment is challenging because it depends on the policies of the index funds and ETFs. However, in some cases, it is possible to buy fractional shares of an ETF with less than $100.
Transaction Costs
An important consideration for investors is how much they must pay in transaction fees to the company or platform when buying and selling units or shares. Currently, major stock brokerages do not charge any fees when you sell ETF shares. However, in the case of index funds, you generally need to pay a type of fee called a sales commission. In other words, although the fee ratio for index funds is lower than for ETFs, usually transaction costs offset this difference.
Tax Strategy
In comparing the tax strategy of index funds and ETFs, ETFs are the clear winners. The reason is that in the case of tradable funds, when you sell ETF shares, only the seller of the shares needs to pay capital gains tax. Therefore, if you consider investing in these financial instruments as a short-term investment strategy and are constantly buying and selling these assets, ETFs are a better option tax-wise.
Index Fund or ETF; Which Is Better?
Determining whether an index mutual fund is better than an exchange-traded fund is challenging. Indeed, the answer to this question depends on your goals as an investor, your view of the market, your risk strategy, your purchasing preferences, etc. Also, you should know that many index funds are available as ETFs on the stock exchange. Therefore, it is possible to trade these funds’ shares based on real-time prices throughout the day with minimal fees. On the other hand, when buying units of index funds, you must be aware that the price of these units is determined at the end of each day, and you must wait until the end of the day to buy or sell these units.
Moreover, in both cases, it is important to note that neither method represents direct investment in the stock market. They are tools for indirect and passive investment in the bond and stock markets. Even bank deposits are included in the asset mix of these funds. Additionally, it is very important to review the recent performance of the fund in both the ETF and index fund investment strategies.
Effortless Profitability with Investment in ETFs and Index Funds
As we have explained in this article, investing in index funds and ETFs does not require a high level of knowledge about trading methods and financial markets. On one hand, these financial tools have a high diversity of assets and carry very low investment risk. On the other hand, typically, ETFs and index funds are managed by investment experts with extensive experience in financial markets. Therefore, by choosing one of these financial instruments, you can experience a hassle-free long-term investment.
Also Read: How to Sell Mutual Funds: A Comprehensive Guide to Achieving Financial Success