ETFs vs Index Funds: Which one is best for you?

Passive investment is an investment strategy where investors track or replicate an underlying index. The aim is to get returns that are in lines with the index and not to beat the index.  

Index Funds and Exchange-traded Funds (ETFs) are two passive investment options. They are very much similar but they have a few differences.

In this article, we will discuss these two types of passive investments and their differences.

What is an ETF?

An ETF is a basket of stocks or securities and replicates an underlying index or commodity. The ETF units are traded on stock exchanges like shares. ETFs offer the best of stock market and mutual fund investment. 

The ETF gives the same weightage to the stocks as their weightage in the index.

You will need Demat account to buy or sell ETF units. 

Index Funds

Index Funds’ asset allocation replicates an index. Index funds are like mutual funds without the involvement of the fund manager. You don’t need ETF to invest in index funds.

Similarities between ETFs & Index funds 

No involvement of fund manager

These investment options come with fewer management costs as these investment options are passively managed i.e., without any active involvement of the fund manager.  

Diversification

Index funds and ETFs are baskets of stocks and securities. So, by investing in an ETF or index fund, you can gain exposure to multiple securities which reduces risk.

Tracking error 

Tracking error is the difference between the portfolio returns and the index’s returns. High expenses and incorrect replication of securities can result in high tracking error. As ETFs and index funds have expenses, you will find tracking error in ETFs and index funds.

Differences between ETF and Index funds

Purchase and Sale

A significant difference between ETF and index funds is that an ETF can be traded throughout the day like stocks, whereas index funds can be bought and sold only for a fixed price set at the trading day’s end.

This issue is not much of a concern for long-term investors. However, for people interested in intraday trading, an ETF is a preferable choice, as individuals can still reap the diversification benefits.

Cost to own them

ETFs and Index funds are cheaper to own from the expense ratio perspective. However, there is another cost to be considered, that is the trading commissions. If any broker charges a commission for your trade, you will pay a fee every time you buy or sell an ETF. The fee then eventually impacts returns for regular traders. But index funds have a higher expense ratio than ETFs.

While buying an ETF, you will also incur a cost known as the bid-ask spread that is not visible while buying the index funds. This is a smaller expense if you buy high-volume and broad-market ETFs.

Finally, in the end, both Index funds and ETF are low-cost options compared to actively managed mutual funds. For deciding between ETFs and index funds, you must compare the expense ratio of every fund, as that appears as an ongoing cost you will have to pay for the entire time while holding the investment.

Moreover, you must also check out the commissions that you will pay to buy or sell the investment, even though this fee is usually less critical unless you are regular with trading.

Making transactions

ETF units can be bought or sold on stock exchanges. Therefore, if you invest in ETFs, you must have a Demat account. You must buy a minimum of one unit and accomplish this in the same way you buy or sell any regular share on a stock exchange through any recognised broker.

Index funds are like mutual funds. In this case, you can invest in an index fund through Systematic Investment Plan (SIP) or a make lump sum investments to buy the units of an index fund.

Conclusion

Index Funds & ETFs are the good investment options for long-term investors. However, for people interested in intraday trading, ETF holds the upper hand as it offers liquidity similar to direct stock investing and reap all the benefits from diversification.

Before going for any investment plan, be it an ETF or an index fund, it is important to find the option that suits you best.

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