Both exchange-traded and index funds have their strengths and weaknesses. Both terms can be interchanged because they are similar in many ways. However, “index funds” are typically used to refer to an indexed mutual fund, while “ETFs” can refer to any type of ETF regardless of its holdings, goals, or fee structure.
Continue reading to find out how these products compare and which one is right for you.
What Is The Difference Between ETFs And Index Funds?
|Fund management style||Active or passive||Passive|
|Expense Ratios||Mutual funds are more affordable than other types of mutual funds||Indexed ETFs are more expensive than active funds, but they have a higher yield.|
|Price||Trades throughout the day determine your determination||NAV determines the price|
Fund Management Style
Although ETFs come in many styles, index funds and index ETFs both fall under the umbrella of “indexing.” Both require investing in an underlying benchmark index. Indexing is primarily because index funds, both index ETFs or index mutual funds, can often outperform actively managed funds over the long term.
Indexing is based on what the investment industry calls a passively investing strategy. Passive investments are not intended to outperform the benchmark indexes or the market.
In the first few years, a top-performing actively managed fund may do well. It has above-average returns which attracts more investors. When the fund’s assets become too large to manage, returns shift from above-average towards below-average.
Most investors miss the above-average returns by the time they find a top-performing active funds. Because you have invested based on past performance, it is rare to get the best returns.
Index mutual funds and ETFs, which are passive investments, have very low expense rates when compared to actively managed funds. This is another obstacle that active managers must overcome and can be difficult to achieve consistently over time.
Many index funds have expense rates below 0.20%. Indexed ETFs may have even lower expense ratios, such as 0.0.10%. 4 HTML5
Passive funds can offer a greater return than actively managed mutual funds by 1% before the investment period begins.
Investors may see a slight advantage in return if they have lower expense ratios than index funds. This is at least the theory. ETFs may have higher trading costs depending on which brokerage you use.
The main difference between the two terms is that “index fund” is usually a mutual fund, while ETFs trade like stocks and not mutual funds. This can impact the price of the investment.
A mutual fund’s price is not a price. It’s the net asset valuation (NAV), at which the underlying securities are valued. Your trade will execute at the fund’s end at the end of each trading day, no matter when you trade. You have no control over when the trade will be executed. 7 8
ETF traders can place stock order. This helps to reduce the pricing and behavioral risks associated with day trading. Investors can select a price at the end of which trades will be executed using a limit order. Investors can select a price lower than the current price to prevent loss at that price by placing a stop order. 9 Investors do not have this flexibility with mutual funds.
ETF trading is determined more by price than NAV. Therefore, you can pay more for an ETF than what the ETF’s assets are worth. Although the price of an ETF is usually close to the underlying securities value, it might not always match.
Which Is Best For You?
Although index funds and ETFs are very similar, the best choice for you will depend on your trading style.
ETFs may be the best for you if…
ETFs trade intraday like stocks. If you are able to profit from price movements during the day, this can be a benefit.
An ETF can be bought early in the trading day to capture the positive trend if you believe the market is moving higher, and you want the market to move higher 10 This can be both a risky and a lucrative opportunity depending on how accurate you are in forecasting the trend.
Index funds may be the best for you if…
Index funds may be the best option for you if you don’t want to miss any opportunity that comes your way. You could be exposed to additional costs by trading ETFs without understanding how they work.
The spread is a part of the tradable nature of ETFs. It’s the difference between the ask price and the bid price for a security. When ETFs don’t have a lot of trading, the spread gets wider and the spread costs increase.
Jack Bogle, the founder of Vanguard Investments, was skeptical about ETFs. Vanguard does have a wide selection. Bogle cautioned that ETFs’ popularity is mostly due to the financial industry marketing. 12 Bogle warned that ETFs’ popularity may not directly correlate with their practicality.
Trading an index like stocks can also encourage trading, which can lead to potentially harmful investing behavior such as poor stock timing or frequent trading that increases expenses.
The Best-Of-Both Worlds Option
ETFs vs index funds doesn’t necessarily have to be a binary choice. You can consider both.
The index investor is not interested in fees and expenses. Therefore, the expense ratio should be the primary consideration when choosing between them. You might find some types of investments that are more advantageous than others. The SPDR gold Shares (GLD), ETF is the best option for an investor looking to purchase an index that closely tracks the price of gold.
Finally, while past performance does not guarantee future results, historical returns can help investors to determine if an ETF or index fund is able to closely track an underlying index.
The Bottom Line
It is about choosing the right tool for the job. ETFs can offer greater flexibility and lower expenses, but index funds are more straightforward in terms of making trading decisions.
Investors can choose to use either one or both. To add variety, you might use an index mutual fund to hold your core and then add ETFs that are invested in specific sectors to increase diversity. If you use investment tools for the right purpose, it can result in a synergistic effect that makes the entire portfolio more than its parts.
This post was written by All Seasons Wealth. At All Seasons Wealth, we provide expert advice and emphasize the importance of creating in-house portfolios to personalize your strategy for asset management, financial planning, and cash management. We utilize research and perform market analysis to provide you with financial planning in Tampa. No matter your needs, we can work with you to develop a consulting solution tailored to you.
Any opinions are those of All Seasons Wealth and not necessarily those of RJFS or Raymond James. Investing involves risk and you may incur a profit or loss regardless of the strategy selected. Investing involves risk and you may incur a profit or loss regardless of the strategy selected. Every investor’s situation is unique and you should consider your investment goals, risk tolerance, and time horizon before making any investment. Past performance may not be indicative of future results.