ETF vs index fund: which is better?

Which are better, ETFs or index funds? In this no-nonsense guide, we compare the similarities and differences.

ETFs vs index funds                                 

Exchange traded fund (ETF) vs index fund: which is better. More importantly, what’s right for you? In this article, we’re going to explain what sets these two investment vehicles apart.

But first, it’s worth noting that the two do have similarities. Whether you go for an ETF or index fund, you’re likely to be investing in a collection of stocks and bonds or tracking activity in a particular index. Enthusiasts believe that both of these funds can offer far superior returns than those that aim to outperform the market by being actively managed.

Exchange-traded funds vs index funds: The difference

Here’s a brief snapshot of some key differences between ETFs vs index funds.

As you can see, there’s a lot to think about when it comes to ETFs vs index funds. Let’s go through each of these points (as well as a couple more) one by one.

Pricing is a big issue. With an exchange-traded fund, share prices are updated regularly throughout each trading session. This means you can buy into an ETF at a low point, or sell during an intraday high. Index funds are a different kettle of fish. Here, you won’t have that flexibility to capitalise on fluctuations during the day. Instead, you’ll only be able to sell at the price that’s been calculated once the session has drawn to a close.

Given the fact that ETFs are traded like shares, you can also use certain order types that allow your stock to be sold automatically when it hits a certain level, either because you want to prevent further losses or lock in profits. Contrast that with index funds. Even if you make an order to sell your holding at 10am, you’ll only know the settlement price come the evening.

Another major sticking point with ETFs vs index funds is the investment requirements associated with them. With an ETF, you can purchase as few or as many shares as you like. The minimum investment amount is the price of a single share. Index funds often require a greater level of financial commitment, meaning that you may only be able to enter into a position if you have a few thousand pounds to spare.

Generally speaking, ETFs are especially worthwhile for those who are dipping their toe into the markets for the first time.

Which is better: ETF or index fund?

Whether you should go for an ETF or index fund often hinges upon what your investment goals are. If you’re in it for the short term, or want to make a profit on fluctuations in the market during trading hours, you may find that an exchange-traded fund is a better fit. On the other hand, if you’re planning to commit to an investment for several years – even decades – an index fund will more than satisfy your requirements.

The next factor we’re going to explore is the associated cost – as well as the choice on offer. Generally speaking, you may find that the management fees associated with index funds are somewhat higher than those provided with ETFs. That said, you won’t have to contend with transaction costs and commission fees whenever you’re making a trade.

One of the main reasons why ETFs have become so appealing to investors over recent years lies in how they allow you to gain exposure to a specific sub-section of the market – such as energy or consumer staples – or acquire a basket of stocks in different countries. Through exchange-traded funds, you can even diversify into commodities and bonds. Index funds are slightly different because they’re designed to cover every single company in indices such as the S&P 500, even if you’re not particularly keen on a certain sector.

A top tip to consider while you weigh ETFs vs index funds is to look at the past performance of competing opportunities. Although you may assume that an ETF and an index fund tracking the S&P 500 would provide similar results, this isn’t always the case. Greater fees can eat into your gains substantially – and if an ETF fails to track the index as accurately as an index fund, this can have a sizeable impact on the end result.

Another compelling point centres on how exchange-traded funds can trigger trading behaviours that might actually affect an investor’s returns in the long run. The fact that ETFs can be traded like stocks could tempt someone to try and time the market (which is an exceptionally bad idea) or rack up considerable costs by entering into trades frequently. The format of index funds does eliminate this.

Of course, there’s absolutely no reason why you can’t use both, either. If you have a significant sum of money that you’re looking to invest long term, you can put this into an index fund. Then, if you fancy being adventurous or want specific exposure to a sector that you believe is going to outperform in the coming weeks and months, you can snap up some ETFs that’ll serve as a complementary investment. All of this helps you to achieve a balanced portfolio.

Both have benefits

Over the years, research has suggested that simply following an index can be a far better approach than trying to beat the market and outperform. Although there may be some years when a winning strategy can unlock impressive gains, a bad call the following year could result in losses even though the index itself is firmly in the black.

All of this has brought into question the wisdom of mutual funds that attempt to perform research and implement bespoke strategies – often at great expense to the investors whose funds they manage.

In 2016, S&P Global released some fascinating research that compared how three indices – the S&P 500, the S&P MidCap 400 and the S&P SmallCap 600 – fared against actively managed funds. Over the course of the year, its study found that 66% of large-cap managers underperformed against these three indices – rising to 85.54% of small-cap managers and 89.37% of mid-cap managers. Each of these managers performed worse over a five-year period, too.

So there you have it: plenty of food for thought as you weigh ETFs and index funds. No two investors are the same, so consider your requirements before getting involved.


FURTHER READING: Bitcoin ETFs explained

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