Index Fund Vs. ETF: Similarities and Differences Stated

Index Fund Vs. ETF: Similarities and Differences Stated
Nakla Team
Fintech Group
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Jan 24, 2023
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Last Updated
Jan 24, 2023
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Exchange-traded and index funds have recently grown in popularity amongst investors. ETFs and index funds are passive investment opportunities that add much-needed diversity to your portfolio. They may look to be the same, yet they are not. This article examines the distinctions to help you better comprehend them.

Index fund and ETF Overview

ETF Overview

ETFs, commonly known as exchange-traded funds, monitor a specific index or commodity. It aggregates clients' funds into a corpus, which is subsequently spent in assets related to the indices or commodities that the ETF follows. The ETF replicates the index by investing in securities similar to the index.

ETFs are among the most essential and profitable products developed recently for small investors. They have several advantages and, when utilized intelligently, are a fantastic vehicle for achieving an investor's investment objectives. This was not previously conceivable prior to the creation of ETFs. Moreover, they have opened up a whole new world of investment choices for retail and institutional financial advisers. They let investors acquire broad exposure to whole stock markets in various industries and regions with relative ease, in real-time, and at a lower price than many other types of investment.

Initially tracking primarily market bellwethers, ETFs have emerged in recent years to monitor various asset types. Several popular ETFs now also follow tailored indexes. Aside from profits, ETF efficacy is assessed by the Tracking Error, which evaluates how accurately an ETF matches its chosen benchmark.

Index Funds Overview

Index funds are exchange-traded mutual funds that follow a specific index, monitor its movement, and are valued among such an index. These are sold on the exchange and are strongly related to the indices they track. In general, index funds using equities as underlying securities pursue a blend of diverse firms in specific proportions that are huge, mid-sized, small-sized, lucrative, volatile, and so on to balance the portfolio.

Is an ETF an Index fund?

Exchange-traded funds (ETFs) are index funds that follow a portfolio of equities. Mutual funds are collections of notes, commodities, and other things that produce returns. Stocks are financial instruments that give rewards depending on performance. However, ETFs can be exchanged (purchase and trade) throughout the day, whereas index funds can only be transacted after the business day.

Similarities between ETF and Index Fund

The following are some of the reasons that make these funds equivalent in nature:

  • Both are categorized as 'indexing' since they entail investing in an underlying stock index. The goal is to outperform actively handled funds in a variety of ways. 
  • Funds are best handled and try to minimize risk via diversification.
  • The Net Asset Value for both the funds is calculated by subtracting the overall worth of the Underlying assets from fees / overall number of shares.
  • These funds have lower expense ratios in comparison to other actively handled funds.
  • Both can track a specified index.
  • They are pooled investment channels in which participants combine their cash into a corpus, which is subsequently invested in various assets.
  • Index funds and ETFs may both allow you to build a well-diversified portfolio. An ETF focused on the S&P 500, for instance, will provide you coverage to thousands of the nation's highest corporations.
  • Another advantage of index funds and ETFs is their good long-term success. An active financial adviser or stock picker may make a few great bets now and then, but few can do it consistently and beat the market. Over five years, approximately 80% of active fund managers fail to achieve, much alone surpass, their target.

Difference between ETF and Index fund

Costs and Expenses:

The fundamental distinction between ETFs and index funds is how they are purchased and traded. ETFs, such as equities, trade on exchanges and are purchased and sold through a broker. Index funds are purchased directly from the fund manager.

As ETFs are traded on an exchange, one must pay a fee to your trader for every transaction. (However, some brokers provide commission-free trading). Dividend payments aggravate the problem of discrepancies in how ETFs and index funds are purchased and traded. Index mutual fund dividends can be instantly reinvested for free into additional shares of the fund. 

When an ETF distributes a dividend, you must leverage the profits to purchase new shares, incurring extra costs and spending hours login into your profile to conduct a quick sale. Several dealers may provide an automated dividend reinvestment plan for a select ETF group.

When it comes to yearly cost ratios – the proportion of assets you'll spend to manage the fund – ETFs often have a tiny edge. However, the expense ratio disparity between commonly traded ETFs and index funds has shrunk and practically vanished in past years. Expense ratios for more narrow indexes, on the other hand, can vary greatly, generally benefiting the ETF.

Structure:

The index funds portfolio imitates the indexes of the stock market. They don't have their volatility. Hence, these funds possess a more significant amount of assets in liquid cash and treasuries in comparison to an ETF. As a result, there is a minimal discrepancy in the performance of such funds compared to the actual index, which is called a tracking error.

Just like mutual funds, ETFs also have their portfolio made up of equities that have the same component as an index. Furthermore, these equities have the same weightage as the corresponding indexes. Nevertheless, the proportion of liquid assets and debt varies from fund to fund. As a result, even though they are part of the same index, the profits from every ETF might differ.

Liquidity:

The simplicity with which an investment may be purchased or sold for cash is a crucial distinction between ETFs and index funds. ETFs, as already said, are purchased and sold like stocks, which means you may purchase or trade them whenever the share market is open.

Simultaneously, index fund transactions are processed in mass once the market closes. Hence, if you place an order to trade shares of an index fund in the afternoon, the transaction will only happen after hours at a cost equivalent to the worth at market close. 

Fund Management Style:

Index funds are passively managed products, whereas ETFs can be either passively or actively managed. Currently, actively managed ETFs account for around 20% of all ETFs in the United States. This means that an investing team is studying businesses and determining strategic options about how to grow the ETF's holdings, which equities to purchase and which equities to trade, and so on.

The design of these active ETFs may be super ingenious. By merely duplicating prominent individuals' portfolios, such as Warren Buffett or Rakesh Jhunjhunwala, an ETF may be formed to match what they are investing in.

Distinction in Expense Ratio:

Both financial instruments have low expense ratios, indicating the cost charged by mutual fund organizations to handle your funds. However, when comparing ETFs vs. Index funds, ETFs appear to be more economical than Index funds in most cases.

Nevertheless, ETF investors should be familiar with the following extra expenses. The charges levied by your dealer, i.e., the stock exchange, are among these additional expenses. The broker's compensation is generally a percentage of the value transacted or a fixed fee per deal. 

This commission or charge is typically a combination of several expenditures such as brokerage, GST, STT, stamp duty, exchange fees, and many more.

Conclusion

Investors are not required to select one single fund between index fund vs. ETF. Both of these, when combined, may form an excellent investment portfolio that provides diversity, the appropriate level of stock market risk, and long-term profits. As a result, an investor must undertake due research and choose the plan that best meets their financial objectives, risk tolerance levels, and investment objective.

Index Fund Vs. ETF FAQs

Are Index funds safer than ETFs?

None of the funds, either index or exchange-traded funds, are safer to trade on the stock market. It depends on what kind of funds you own and the risk associated with it. It is a well-known fact that equities will always be volatile and riskier when compared to any bonds. However, equities will always give you a greater rate of returns.

Which is better ETF or an index fund?

ETFs are said to provide more tax benefits than index funds mainly because of the way they are constructed. When you trade an ETF, you usually sell it to another person interested in purchasing it, and the money comes straight from them. On the other hand, capital gains taxes on the transaction are solely your responsibility.

Why are ETFs better than index funds?

Exchange-traded funds have substantially more volatility than index mutual funds as they are sold in a marketplace during the day. Investors can buy and sell shares at any time throughout the day, but index mutual fund transactions are completed in mass at the end of the day. 

Because they are traded on an exchange, ETFs provide more diverse investing possibilities. Limit and stop bets can be placed by investors. They may leverage margin accounts to trade stocks and purchase options contracts on ETFs.

Nakla Team
Nakla Team

Nakla team aims to provide their customers with all the latest happenings in the financial market and keep them updated with trending terminologies. We have the resources that help you upgrade your investment game and make your investment journey seamless.