Indexation techniques (or passive management) originated in the US in 1970, and since then, it became very popular. Whether you are a novice in the stock market or an expert investor, you have two great passive management investment options: exchange-traded funds (ETFs) and index funds. They have many things in common, and at the same time, there are a few differences between them. When it comes to selecting one of them, the choice varies from investor to investor. Furthermore, there are several factors that investors consider before making a suitable choice.
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If you are also in the process of selecting one of them, then this post will help you in making a well-informed decision. In this post, we’ll walk you through a comparison between the two investment strategies and even highlight specific use cases where an investment method is most suitable. But, before jumping into the comparison, let’s understand the basics:
ETFs and Index Funds: What they are and how they work?
As an investor, you can select the most suitable investment option only when you are clear about the basics. So, let’s find out what are ETFs and index funds and how they work.
What are the ETFs?
Exchange-traded funds (ETFs) are funds that hold assets such as stocks, commodities, or bonds. They track a wide variety of bond and equity indices such as the S&P500 as well as a range of sector indices and industry baskets, so it is an excellent way to diversify your investments. For example, Gold ETFs tracks gold while the SPDR S&P 500 ETF tracks S&P 500 Index.
ETFs are listed and traded on a stock exchange. Unlike mutual index funds that are traded once a day, the price of an ETF fluctuates throughout the day. Furthermore, ETFs are more liquid and cost-effective than mutual funds. They come with a multitude of features, making them suitable for newcomers in the stock market who have a little amount of money to invest. The ETFs allow you to build a diversified portfolio with considerably low investments.
ETFs deal with the fractional shares of the index where the funds are initially raised, and then a portfolio of index stocks is created at the back-end to mirror the index. The fund doesn’t require any redemption request or fresh application once the portfolio is successfully created. If you want to buy and sell it like equity shares, ETFs have to be listed compulsorily.
How Do ETFs Work?
ETFs have similar characteristics of both shares and mutual funds. In the stock market, they are usually traded in the form of shares produced via creation blocks. The best thing about these funds is that they are listed on all major stock exchanges and can be bought and sold as per the requirement.
The share price of an ETF, however, is directly proportional to the cost of the assets. If the cost of one or more assets increases, then the share price of the ETFs will proportionately increase.
As a matter of fact, “The dividend value received by the share-holders of ETFs largely depends upon the asset management and the performance of the concerned ETFs Company”.
Pros of Investing in ETFs
- Cost-Effective: Exchange-traded funds generally have low expense ratios. Though they can be bought and sold like stocks, many online brokers offer commission-free ETFs, even for investors with minimal capital. It would be incredibly helpful to young investors, as they cannot afford to incur high fees and commissions.
- Liquidity: There’s no arguing that ETFs are very liquid and can be traded throughout the day. It becomes beneficial to young investors who don’t want to lose their investment immediately, and they would preserve limited capital.
- Investment Management Choice: ETFs enable investors to manage their investments as per their needs: passive and active, irrespective of their financial condition. There is no restriction on frequent trading. ETFs can be bought or sold throughout the day.
What is the Index Fund?
An index fund is a mutual fund constructed to effectively track various components of a market index (a group of securities representing a segment of the market). An index fund generally mimics the financial index’s performance and composition and pursues a passive investment strategy. For example, the Index fund of S&P 500 tracks it, while the index of Nasdaq Composite will track all 3,000 stocks listed on its exchange.
There are thousands of index funds available in the market, and they differ according to the indexes they track. Index funds are available for an extensive gamut of investments beyond stocks, including real estate investments, commodities, bonds, and investment in different sectors. Some stock index funds own limited stocks, while others own thousands of different stocks. No matter what index they track, an index fund’s main goal is to match the performance of the underlying index.
How Does the Index Fund Work?
For those who don’t know, index funds have fund managers whose prime responsibility is to build a portfolio with holdings that exactly mirror the security of a particular index. Hence, instead of stocky picking, the manager ensures that the fund successfully tracks its underlying index. The index is created and maintained by the third-party index provider. Hence, the fund manager needs to buy the investments that the index provider includes in the index and make purchases when the provider makes significant changes to the index.
Index funds can be structured in two primary ways.
- Index mutual funds directly offered through mutual fund companies.
- Index exchange-traded funds that trade on stock exchanges, allowing buying or selling shares at any point by anyone with a brokerage account when the stock market is open for trading.
Pros of Investing in Index Funds
- Saves times: Index funds can help you save time and effort as you don’t need to research individual investments or manage a portfolio. A single index fund can give you a diverse pool of investments instead of choosing individual stocks or bonds.
- Seamless management of portfolio: Regardless of the amount to invest, index funds are available to all investors. It will help an individual to remove all the psychological biases and let them focus on the management of the portfolio.
- Removal of negative elements: When you invest in Index Funds, you’ll likely to remove all these negative elements.
Here’s the list of the biases:
- Loss Aversion: It is associated with the fear of losing substantial capital that causes investors to sell at sub-optimal times and invest in lower-risk equities, ultimately producing lower returns.
- Narrow framing: It refers to making crucial investment decisions without adhering to the context of a portfolio.
- Improper Accounting: It includes biases such as taking undue risks in a single point while completely overlooking the rational risk.
- Anchoring: Focusing on the past, instead of adhering to the rapidly changing market, is another bias.
- Unrealized Lack of Diversification: It is when an investor thinks that a portfolio is diversified despite investing in highly correlated assets.
- Irrational Optimism: It refers to believing that good things will happen to you at every point of investment.
- Herding: When investors tend to copy the behavior of others, it is termed as herding. It usually results in buying at a high cost and selling at a considerably lower cost.
ETFs vs. Index Fund
Now that our basics are clear, let’s discuss a few parameters that will help you to select a suitable investment option according to different situations:
The most significant difference between index funds and ETFs is the method in which these can be traded. In the case of ETFs, you can trade throughout the day just like stocks and their price keeps fluctuating. In the case of index funds, you can buy or sell them at a fixed price of the day. The price is usually set after the end of the day.
ETFs: ETFs track the indexes like the S&P 500 by holding all of the index’s underlying assets. Each of the stocks would weigh the same as it has on the index. For liquidity purposes, some parts of its assets may be held in cash or securities. Returns of an ETF are quite similar to that of the index.
Index Funds: When it comes to the portfolio of index funds, it replicates a stock exchange index. They have a relatively higher percentage of assets in cash and liquid securities than ETFs because index funds have no liquidity.
ETFs: These kinds of funds can be bought and sold on a stock exchange. So, if you want to invest in ETFs, you can do it through a broker or brokerage platform.
Index Funds: These are mutual funds, and their units can be bought collectively or periodically through a fund manager.
ETFs: ETFs usually have a lower Total Expense Ratio as it only includes annual management charges, typically 0,5% or less, and brokerage fees.
Index Funds: These funds, on the other hand, come with multiple charges. You are liable to pay a fee for the transaction above a certain amount. The index funds come with an expense ratio in the range of 1% to 1.8%. Hence, if no transactions are made, investors are required to pay expense ratios.
ETFs: The minimum investment value of ETF is quite less than that of index funds. Many sellers offer fractional shares to invest in ETFs, and you may even buy a single share.
Index Funds: There are minimum limits set for index funds, which are quite high for young investors at times. For instance, Vanguard has set a minimum investment limit of $3,000 of its index fund.
So, this was an evenhanded comparison between ETFs and index funds. As you could see, ETFs seem to have a little advantage over index funds for young investors as they come at a significantly lower cost. But you also cannot track markets and make the right decision because of inferior market knowledge. On the contrary, you can invest in direct index funds as professional fund managers manage them. They would help you make the right decisions depending on the market scenario. So, you should make the final choice after considering all the factors.