Difference Between ETF and Index Fund

ETF vs Index Fund – Which Is Better?

Index funds and exchange-traded funds are no doubt excellent wealth-building tools that deliver amazing results in varied investment scenarios. But you must be aware that most of the time, index funds are often mistaken as ETFs and vice-versa. 

ETF vs index fund both are low-cost and passively managed. Along with that, they are one of the best investment vehicles that offer built-in diversification. In short, these funds bundle several securities into one investment while offering broader exposure to several businesses. Considering these qualities, an ETF vs index fund is ideal for the average investor.

So to understand both of them in a better way, let's compare these two types of investments to help you decide which one to go with.
 

What is an ETF?

An Exchange Traded Fund is an investment vehicle composed of a mix of assets like bonds and stocks and directly traded on a market exchange. Moreover, it can be tailored to offer exposure to various market segments, such as sector or asset class.

Their main motive is to track the performance of a market segment, or, you can say, index, which helps enhance their appeal to the average investors looking for market returns with the benefit of diversification. Furthermore, ETFs follow the market, but other investments, like mutual funds, aim to beat the market.

If you talk about the benefit of ETFs over other funds, it is that they can be traded like stocks. These traded funds are transacted as soon as possible once they are submitted for execution. On top of that, they are passively managed and have low operating costs that deliver higher returns to almost every investor. 

Additionally, ETF vs index funds are of higher liquid and offer tax advantage wherever they are applied. 
 

Define Index Fund?

An index fund is a kind of mutual fund with a portfolio constructed that perfectly matches or tracks the various components of a financial market index like the Standard & Poor's 500 Index. With the passing of time, this index mutual fund delivers broad market exposure, low portfolio turnover, and low operating expenses. 

These index funds are best considered for core portfolio holdings like retirement accounts, such as individual retirement accounts and 401 (k) accounts. According to Legendary investor Warren Buffett, index funds are one of the greater havens for savings for later years of life. He said rather than picking out individual stocks for investment index funds, it is best for the average investor to buy all S&P 500 companies at a very low cost. 

Index funds are a type of passive fund management system in which a fund manager builds a portfolio whose holdings mirror the securities of any of the particular indexes. Moreover, the portfolios of index funds change suddenly when their benchmark indexes change. 

That means if any of the funds follow a weighted index, its manager will periodically rebalance the overall percentage of varied securities that reflects the weight of their presence in the benchmark.
 

What do Index Funds and ETFs Have in Common?

Both indexes vs ETFs are bundled together in a number of individual investments like stocks or bonds like a single investment. This is the main reason it is one of the popular choices among investors for a number of reasons. They are: -

●    ETF vs index fund helps to create a well-diversified portfolio.
●    They are passively managed, which means the investments within the fund are directly based on an index like S&P 500. 
●    They are the best for long-term investors as they outperform actively managed mutual funds. No doubt they follow the ups and downs of the index during tracking but overall show positive returns. 

Mutual funds that are actively managed always perform in an excellent way in the short term as fund managers make great investment decisions based on current market conditions and as per their experience. 
 

Differences Between ETFs and Index Funds

After reading the above post about an ETF or Index Fund, you might get an idea of what they are. But to know more, there are many other differences which will help you to understand both of them in a better way. They are: -

1.    The minimum investment required

In most cases, ETFs have very low investment as compared to index funds. The reason is they are traded like stocks and are purchased as whole shares. That means you can buy an ETF for the price of just one share, which is known as the ETFs market price. 

But if you talk about index funds, brokers rarely offer a bit higher price than any of the typical share prices. So, if you are planning to invest a minimum amount, always go for an ETF over an index fund with your own share price which is affordable. Moreover, looking to go with an index fund is also a great option without investment. 

2.    The capital gains taxes you’ll pay

Here if you talk about ETFs, it delivers tax benefits as compared to index funds, and this credit goes to its structure. That means if you plan to handover an ETF to any other investor, the money will come directly from that investor. In short, the capital gains taxes with the selling of the ETF will be yours.

But in an index fund the owner has to redeem this cash directly from the manager and they will take your securities to produce money for you. In this process, the net gain is passed to each investor that has shares in your fund. That means,  you will not get capital gains money without selling even one share. 

Overall, ETFs deliver more benefits than Index Fund.

3.    The cost of owning them

In regards to cost, both ETFs or index funds are very easy and affordable to own in the context of expense ratio. That means it can cost you a minimum amount than 0.05% of total investment annually. 

But there is another cost which you have to pay while buying an ETF and index fund in trading commissions. But, if you are interested in ETFs, the broker will take some charge as a commission for trades when you purchase or sell an ETF, which will again turn into returns if you are trading regularly.

No doubt, in the case of index funds also you have to pay some transaction fee while buying or selling, but there is a difference in the cost, which you have to consider before choosing one. In short, both of them are low-cost options as compared to various other mutual funds, but you have to compare the expense ratio of both before selecting one. 
 

Conclusion

ETF vs index funds are excellent ways of investing to make your future safe and secure as they are low-cost, maintenance, and risk that deliver steady returns with the passing of time. But on the other side, you have to remember both the investments don't suit all. 

So, when you choose either investment option, you must check which asset the particular fund is following and ensure you are comfortable with the diversification going inside the fund. Once you do this, compare both the fund's expense ratio and number of other fees which you have to pay.