ETF vs Index Funds: Key similarities and differences

There are two fundamental styles of investing — active and passive. Active investing involves frequent buying and selling of stocks with the goal of surpassing average index returns. Meanwhile, passive investing involves building a portfolio of securities that can efficiently track a market index and mirror the returns given by them during a particular period. 

Exchange-traded funds (ETFs) and index funds are popular passive investment vehicles that pool investors' capital into portfolios that match a particular market index’s performance. 

Whether you are a seasoned investor or someone new to investing, an ETF or index fund can suit your needs if you are looking for passive investment vehicles.  

Let’s begin with understanding index funds and ETFs individually before discussing the differences between them:

What are ETFs?

An exchange-traded fund is a pooled investment vehicle that invests in assets ranging from traditional investments to alternative assets like commodities or currencies. In that sense, ETFs are similar to mutual funds. However, unlike mutual funds, these are marketable securities that can be traded on an exchange, just like stocks. Investors can buy or sell ETFs through a brokerage firm on a stock exchange. Further, ETFs also have a ticker symbol and intraday price data. 

Notably, there are several types of ETFs, including Index ETFs, Fixed Income ETFs, Sector and Industry ETFs, Commodity ETFs, Style ETFs, Foreign Market ETFs, Inverse ETFs, Leveraged ETFs, Actively Managed ETFs, Exchange-traded Notes (ETNs) and Alternative Investment ETFs.

What are Index funds?

An index fund is a type of mutual fund that seeks to track the returns of a market or benchmark index. The index fund manager builds a portfolio that closely replicates the benchmark index by investing in all or a sample of the companies that are included in that index. 

Notably, a market index is a statistical indicator that measures the performance of a basket of securities (like stocks or bonds). For example, in India, Sensex is a broad-market index of the BSE, and the NIFTY is that of the National Stock Exchange (NSE). These indexes indicate the weighted average performance of some of the largest listed companies in India across various sectors. 

The index fund manager mostly follows a passive investment style and aims to maximize portfolio returns over the long term by not trading frequently. However, the fund manager tries to make sure that the weightage of the stocks in the portfolio replicates their weight in the benchmark market index. Whenever the weight of a particular security, or securities altogether, changes in the benchmark index, the fund manager needs to rebalance the portfolio in order to avoid making tracking errors.

ETF vs Index Fund

Despite these investment vehicles sharing several similarities, market participants remain confused about whether to pick an ETF or an index fund. To get a better grip on the subject, let’s study the differences between an index fund and an ETF:

The minimum investment amount needed:

Market participants do not require a huge corpus to park their money in ETFs purchased in units. In fact, they can invest in ETFs with an amount equivalent to buying a share of any stock. Meanwhile, index fund managers sometimes set a minimum investment amount mandatory to enter the fund, restricting investors' ability to invest in them. 

ETFs can be the right choice for market participants who want to invest small capital as they come with no minimum capital mandate. 

Capital Gains Tax Liability:

The profits from ETF trading are liable to similar capital gains tax liabilities as traditional stock market trading. On the other hand, capital gains tax liabilities in index funds can arise every time a participating investor from the pool of funds cashes out of it, and the fund manager returns the invested amount and sells the securities at a gain. 

The cost of owning them:

To begin with, investors should first check the expense ratio, which is a nominal charge for both types of funds for managing the portfolio.

Another cost that deserves a look is whether any trading activity will result in incurring any commissions in the form of brokerage in the case of ETFs and transaction fees in index funds. An additional cost in the form of a bid-ask spread should also be considered while choosing ETFs. This cost shouldn’t be a problem if you are looking at the broad market ETFs with high trading volumes.

The winner will be the investment vehicle with a lower expense ratio. 

Conclusion

After studying the basics and the differences between ETFs and index funds, we can safely conclude that both have their own benefits and drawbacks. The selection will largely depend on the investors’ time horizons and preferences. 

ETFs can be a good option if a market participant is looking for a simple instrument that provides good diversification benefits and can generate returns in a largely volatile environment.

Meanwhile, investors with a long-time horizon and who need a more stable and disciplined approach can pick index funds. Always remember, the father of indexing, John Clifton Bogle, once said “Don't look for the needle in the haystack. Just buy the haystack!"

FAQ

Q. Which is better, ETF or Index Fund?

The right investment vehicle depends upon the investor’s goals and time horizons. ETFs have a low expense ratio, but index funds look attractive for reaping handsome long-term returns. 

Q. Which offers a higher return, ETF or Index fund?

ETFs can generate higher returns in the short term, but index funds are a better choice for investors with a long-term horizon.