Passive investment vehicles have become immensely popular in the last few years – and for good reasons. Most actively-managed funds have struggled to outperform the S&P 500 index after expenses. Passive investment vehicles such as exchange-traded funds (ETFs) and index funds don’t aim to outperform their benchmark index. They are simply designed to match the performance of an index. If you are a beginning investor, you might be wondering whether to start your investment journey with ETFs or index funds. In this ETF vs index fund comparison, let’s check out how they differ and what factors you should consider while making a decision.
It’s natural for value investors to get confused between them because they are both passively managed. Both ETFs and index funds are based on the philosophy of “If you can’t beat them, join them.”
Most actively-managed mutual funds and hedge funds that charge exorbitant fees struggle to beat the popular S&P 500 index. If you stick with them, you’ll likely get a lower return in the long run than the index. So, why not get the same returns as the index?
ETFs vs index funds: Both track an index
ETFs and index funds track a particular index. The most common index in the US is the S&P 500, which consists of the 500 largest stocks in the US by market capitalization. Every index is weighted by market capitalization. It means companies with higher market cap have more weightage in the index.
There are many other indices such as the CRSP U.S. Total Market Index, Wilshire 5000 Index or the Russell 3000 Index. Tracking the performance of an index is called passive investing.
If you wanted to mimic the performance of, say, S&P 500 by yourself, you’ll have to buy shares of each of the 500 stocks in the same proportion as they are in the index. And you have to adjust your portfolio from time to time as constituents or weightage of the constituents in the index changes. This is nearly impossible, especially when you add the brokerage fees and other costs.
ETFs and index funds take all the hard work out of the equation. They try to mimic their benchmark index as closely as possible. Thanks to their scale, there is minimal tracking error. And they charge a pretty small fee, which is usually a percentage of your investment. The expense ratio of index funds and ETFs is often lower than 0.20%.
When you buy shares of an index fund or ETF, you are technically purchasing a portion of the underlying portfolio.
Exchange-traded funds
As the name suggests, an ETF is listed on a stock exchange and trades like a stock. The price of an ETF fluctuates constantly, and reflects the real-time price of securities within its portfolio. You can buy and sell shares of an ETF throughout the day.
Since ETFs trade intra-day like stocks, they allow you to benefit from the price movements during the day. If you believe the market is going higher, you can buy shares of an ETF and take advantage of the upward movement.
Index funds
Index funds are more like mutual funds, except that they are managed passively and track a particular index. Just like ETFs, index funds don’t require active management or stock-picking. Index funds pool money from investors and issue them shares. The shares represent the underlying portfolio.
While ETFs trade throughout the day with price fluctuations, index funds declare their net asset value (NAV) only at the end of the trading day. If you redeem shares, you’ll get the price at which the market closed. You can’t take advantage of ups and downs during the day.
ETF vs index funds: Factors to consider
There are a number of things you must consider before deciding which of the two suits you. Here are some of them.
1- Expenses
Expenses could really eat into your long-term returns. Both ETFs and index funds have much lower expense ratios than actively-managed mutual funds. But ETFs usually have even lower expenses than index funds. For instance, the Vanguard S&P 500 ETF has an expense ratio of just 0.03%. The comparable Vanguard 500 index fund has an expense ratio of 0.14%. Both of them track the same S&P 500 index.
There is another expense you should not ignore. Since ETFs are bought and sold just like stocks, you have to pay commission to your broker, which could make it more expensive. Many brokerage firms have started offering zero-commission trades on ETFs amid fierce competition. But you should still check the trading costs. Index funds don’t have a transaction fee.
2- Investment amount
If you are just starting out, you’ll likely be investing a small amount every month. Index funds typically require a specific minimum amount to start investing. ETFs don’t have any such minimum requirement. If you have enough money to purchase just one share of an ETF tracking the index of your choice, you can execute the transaction.
Since ETFs have a share price, you have to round up or down the amount you are planning to invest. If you have $100 to invest and the stock of an ETF is trading at $12 per share, you’ll have to buy eight shares for $96 or nine shares for $108. Most brokerages don’t allow investors to buy partial shares of ETFs.
In contrast, index funds typically issue partial shares to investors. If you are investing $100 in an index fund with net asset value (NAV) of $12, the fund will allot you 8.33 shares. There is no cash left uninvested.
3- Taxes
Typically, ETFs are more tax-efficient than index funds. Investors will have to pay capital gains taxes only after they sell shares. You don’t have to worry about capital gains taxes for as long as you hold the shares. Index funds have to pay capital gains taxes as they trade shares within their portfolio.
But the ETFs’ tax advantage disappears if you invest in ETFs or index funds through tax-advantage instruments such as 401(K).
4- Most importantly, your own behavior
ETFs give you the freedom to buy their shares throughout the day. It means the irrationality of your behavior comes into play when investing in ETFs. You’ll be buying and selling shares manually at the time of your own choosing. It will tempt you to time the market and indulge in trading with short-term focus, which could hurt your long-term returns. Additionally, your broker might encourage you to buy and sell frequently because that’s how they earn money.
Index funds allow you to automate your investing. Once you set it up, the index fund company will automatically withdraw a specified amount from your bank and invest it. You can choose whether you want to invest monthly, quarterly, or yearly.
ETFs vs index funds conclusion
Now that you have a fair idea about ETFs and index funds, you can decide which one works better for you. For beginners, it’s better to start with index funds because it takes your behavioral swings out of the equation and it makes life easier for you. Your behavior has a much bigger impact on your long-term returns than expense ratios. Don’t underestimate it.
