etfs vs index funds which is better investment

ETFs vs Index Funds, Which is the Best Investment?

When it comes to ETFs vs. index funds, we often get confused. These investments share some similarities because they are both passive investments. ETFs and index funds mainly mimic the performance of a specific market index. This again raises a question: Are ETFs and index funds similar, and if not, what differences do they share? And most importantly, which is better, ETFs or Index Funds? This is what this guide is all about. 

Index Fund vs. ETF: An Overview

Key Highlights

  1. Most ETFs are index funds that mimic a benchmark index.

  2. An index fund is a mutual fund or ETF that invests in a basket of securities to mimic an underlying benchmark index.

  3. Index funds and ETFs are passive investment options because the manager adjusts its holding only when the underlying index changes.

  4. As index funds are passive investments, they are low-cost investments and offer better returns than actively managed funds.

Index Fund

Index Funds are similar to Mutual Funds that spread investments and diversify them in shares, bonds and commodities. These funds try to mimic the underlying asset like the S&P 500. As in Index Funds, the investor invests risky shares with lower risk, this fund ensures that the investment does not fall from the benchmark. Index funds give attractive returns with long-term wealth creation benefits, and hence, they have been a popular choice for investors who conveniently want to invest in passive investment options.

Characteristics of Index Fund

Index funds are a type of mutual fund in which investors can invest and redeem their investments at their convenience. Many investors prefer index funds because they offer growth opportunities and dividend options, which helps them choose their risk appetite. 

Since professional fund managers manage index funds, they try to minimise losses and maximise investors' profits. However, being a passive investment, the fees for managing these funds can be relatively higher, covering the manager and AMC charges, which can be costly for a few investors. The good side of index funds is that they have lower expenses and fees than actively managed funds.

ETF or Exchange Traded Fund

Exchange-traded funds are like a basket of assets traded on stock exchanges, just like regular stocks. You buy them and sell them throughout the day, priced at the end of the day. However, you have to pay the transaction charges. The bright side is that ETFs generally have lower taxes and management fees. An exchange-traded fund can be a good option if you want to consider a low-cost investment. 

Characteristics of ETFs

Exchange-traded funds (ETFs) are primarily traded in intraday shares, and the profit is priced at the end of the day. They are transparent in nature, and investors know where their investments are allocated. ETFs are also affected by the share market as these transactions take place in real time. A few examples of ETFs are industry ETFs, bond ETFs, currency ETFs, Commodity ETFs, etc.

ETFs have a low expense ratio but a high trading cost. Investors can receive dividend income, which they can reinvest in the stock market. ETFs are vulnerable to market liquidity but face risk during a bear market trend. While considering ETFs, investors update their daily portfolio as they enjoy the flexibility of buying and selling at their convenience, unlike index funds. 

Which is better, ETF or index funds? 

It is good to consider a few factors before deciding which is better, ETF vs index funds.

1. Fees and Expenses

The main difference between ETFs and mutual funds is how you buy and sell them. ETFs are traded similarly to stocks; therefore, you need a broker to do this. On the other hand, index funds are brought directly from the fund manager. Since ETFs are brought and sold on an exchange, you pay a commission to your broker each time you make a trade. However, some brokers may also offer commission-free trading. 

Regarding the expense ratio, ETFs hold the upper hand as they come with a lower annual expense ratio; however, this difference has disappeared as ETF and index funds have been widely traded in recent years. If you go for less common indexes, ETFs might give you more favourable expense ratios.

2. Minimum investment

If you are a beginner, you can invest in an ETF by buying a single share, the easiest way to start investing with very little capital. Many fund managers have even lowered their minimum investment for their most popular index fund. Since ETFs require no minimum capital investment, they have gained popularity among investors with little capital.

3. Tax implication

Generally, ETFs are more tax-efficient as you have to pay capital gain taxes on any profit you realise after selling shares of an index fund. In ETFs, you do not pay taxes when holding it in the ETF portfolio that the manager adjusts. On the other hand, index funds require you to buy and sell assets to stay with the index. Any capital gain taxes from these transactions ultimately affect the net asset value of the fund portfolio. This impacts the overall value of your shares.

4. Liquidity

Liquidity means how easily you can turn your investment into cash. This is what sets ETF and index funds apart from each other. ETFs are traded like stocks and offer flexibility to buy or sell whenever this stock market opens. On the other hand, index fund transactions are done similarly to a mutual fund that happens in bulk after the market closes. If you want to sell your index fund today, the deal will close later after the market closes. For traders, this can create a problem, but if you are considering a long-term investment, it matters little.

Why Should I Consider Investing in an Index Fund Over an ETF?

There might be several reasons for choosing an Index Fund over an ETF. 

1. Index Funds are widely traded.

Index Funds, being mutual funds, are a popular form of investment that results in frequent trading. The reason behind this popularity is the ease they offer investors to buy and sell index fund shares. This contributes to its widespread trading activity.

2. Index funds are easier to reinvest

Similar to ETFs, index funds also offer dividends. However, unlike ETFs, Index funds offer easy reinvestment of dividends. In index funds, with dividends, you can purchase additional shares automatically. This avoids the additional transaction cost. They are good investments for those looking to compound their returns over time.

3. Index Funds diversifies risk.

Index funds are typically designed in such a way that they replicate the performance of a specific market index. This includes various securities, which provides diversification. This diversification helps to mitigate the risk associated with few stocks. 

4. Index Fund gives Systematic Investment Plan. 

Index Funds offer a Systematic Investment Plan (SIP). With SIP, you can regularly contribute to index funds. Index funds are a good option for long-term investments and building a portfolio. On the other hand, ETFs, which are traded on exchanges, do not offer SIP. 

Why is ETF cheaper than index Funds?

There are a few reasons why ETFs are cheaper than Index Funds. 

Many ETFs are Index Funds, and tracking an index fund is less expensive than actively managing it. Also, Index-based ETFs are cheaper than index-based mutual funds. When investors want to buy shares of an ETF, they manually enter an order with the brokerage.  

When trading an ETF, you do so with other investors or traders, not the fund company. This implies that the company doesn't handle the order, send the paperwork, or enter the market to process your order. This saves a lot of time and work, ultimately saving you money. 

What is a safer ETF or Index fund? 

Safety is the biggest concern when it's between ETF and Index Funds. Many new investors may need clarification about what is safer and what to choose. The more straightforward explanation is that one isn't safer than the other. It mainly depends on what stocks the fund owns. If you have decided to invest in ETF or Index funds, the long-term investment can be a safer choice. You benefit from lower fees, diversification and the incredible performance of index-based investing.

Final words

ETFs vs. index funds can confuse you. Both these investment options share similarities: they are tax-efficient and sustainable long-term investment options. However, they differ because ETFs can be traded intraday while index funds offer long-term investment options. Now you know which is the better option, ETF or index fund. Before investing, it is always good to consider your risk appetite.

Read Also:

  1. ETFs vs Mutual Funds

  2. Crypto Vs Stocks

05 Feb, 2024

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