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Knowing the differences between an index fund and an ETF is important as these could help you with your finances and your strategies as an investor, both in the short and long run. But what are these things exactly, and which among them should you choose?
A lot of financial managers and professionals would understand that it is natural to get confused on these things because of some characteristics (like, for example, both are managed passively, yet one is more actively engaged with than the other).
One major characteristic that differentiates ETFs and index funds is you can buy and sell trades any time of the day, while with index funds, you can only buy or sell with prices already set at the end of the trading day.
Both types, however, have clear differences, and it would help you make more informed decisions as you buy or sell your investments in the future.
Index Fund Vs. ETF: An Overview
When it comes to investing, it is important to understand what makes an index fund and an exchange traded fund (or ETF) crucially different from each other. For one, ETFs are usually known to be more convenient and even flexible than most mutual funds.
Similarly, ETFs are those that can be easily traded when compared to traditional mutual funds and index funds. You can even purchase and sell ETFs at any time and cost lower than other mutual funds where they are only priced after the day has ended.
Furthermore, index mutual funds are usually perceived in the market as somewhat pooled investment avenues that are managed by an investment advisor, or financial management professional. An ETF on the other hand, is seen as baskets of securities that are being actively managed and traded in the market, just like stocks.
Difference Between ETF and Index Fund
|Index Fund||Exchange Traded Fund|
|Trading- Sell and Buy||Priced only after the day has ended||Any time of the day|
|Activity in the market||More passive||More active|
|Expense Ratio||Relatively lower||Relatively higher|
|Market Liquidity||Less liquid||More liquid|
What Is An ETF?
As pointed out earlier, ETFs are incredibly liquid on the market (which in essence, means that you can trade these easily). Because they are highly liquid, the prices for these funds go down or up throughout the duration of the day. If you invest in ETFs, you will usually need to set aside a commission fee to some brokers in the market each time you make a trade.
It is, however, very notable that ETFs are typically and normally passively managed in the market, as these attempt to come up to par with an index benchmark, rather than outperform it. Also, if you are a person who wants to be more actively engaged in the market, and would want to be more, sort of hands-on on your investments, then ETFs would be more suited for people like you.
What Are the Types of ETFs in the Market?
1) Stock ETFs
Stock ETFs, in hindsight, is something that gives investors the opportunity to engage with baskets of equities without having to buy individual stocks in a specific sector of the market. The following are a couple of characteristics for stock ETFs:
- Charges for management fees are low;
- Stock ETF is ideal for new investors that eye for low costs with actively managed returns.
- Stock ETFs is a good choice if you would want to diversify your financial portfolio using lower costs.
2) Sector ETFs
A sector exchange traded fund or sector ETF, is, as compared to stock ETFs, an investment that you would build through specific industry sectors. Here are the things you should know about this traded fund:
- You can use a sector ETF to invest in an entire and specific industry without having to put together the individual funds and stocks belonging to that sector;
- Because of its high liquidity, there barely are any tracking errors from the underlying index.
- Assets are also passively managed when in an underlying index.
3) Commodity ETFs
As the term implies, these are goods that are being used as inputs in the economy. Those basic goods are seen as a potential for investments that can help cushion economies from the traps of inflation. Engaging in this needs to have a portfolio manager as well. But, what makes this different from the other ETFs in the stock market?
- Commodity ETFs are avenues for investors to have less expensive as well as accessible opportunities to various commodities in the market index.
- Commodity ETFs, exist as wide arrays of goods in the market, from gold to oil and even to agricultural goods such as livestock;
- This type of ETF can, when designed, impact your risk as an investor, including your returns on your investments and your tax portfolio as well.
4) Bond ETFs
Bond ETFs are investment types that are usually invested specifically in financial bonds. It may look the same as a bond mutual fund because both of them carry on a portfolio of bonds but just with varying trading strategies.
- Just like a stock ETF, bond ETFs are traded and managed very much passively, especially on the stock market.
- Because traditional bonds exist and are relatively inaccessible to investors that have less money, bond ETFs make it easier for investors to engage in the stock market because they trade in major indexes and major stocks, such as the New York Stock Exchange.
5) Currency ETFs
What makes currency index ETFs very much different from other exchange traded funds is that they are financial items that are designed to give exposure on investments to foreign currencies (also known as forex). As usual, these are also being managed passively in the stocks. Here are a few other features:
- With currency exchange traded funds, you won’t have to be burdened in investing with individual trades because of being exposed to various foreign exchange funds.
- An investor like you can use currency funds like this to study forexes in the market, or provide a buffer for yourself from currency risks, or simply to diversify your investments and funds portfolio.
- A currency traded fund may include having cash deposits, forex contracts, and even short-term debt that is denominated in a particular currency.
6) International ETFs
The last but not the least category of an ETF is an international ETF. An international ETF revolves around specializing in foreign-based securities in the market.
- You can track global markets, or monitor a benchmark index of a specific country using an international ETF.
- When investing, you can not only diversify your financial portfolio with an international ETF, but you can also expand your political and geographic risks in the market that are associated with such portfolios.
What Is an Index Fund?
Index fund shares is a branch under the category of a mutual fund that is designed to observe, track and compete on aspects of the financial market index. This includes the S P 500 index. These types of funds are expected to keep the market exposed to broader opportunities and with a lower expense ratio.
If you would like to maintain competitive retirement accounts, then an index fund should be the ideal financial portfolio holding for you. 401k accounts and IRAs are usually affiliated heavily on index funds. In other words, you use such funds to rather imitate the composition and performance of an index in the financial market. These have lower fees and operating expenses when compared to actively managed funds (meaning these are managed passively as well)!
Index funds are relatively more long term in nature, meaning, your index returns and capital gains for the fund are meant to get back to you at a relatively longer period of time. As compared to ETFs which are relatively actively managed funds, index funds are for those people who are more conservative and those who would take rather lesser risks when it comes to their funds.
Read more: Index Funds for Dummies
How Do ETFs and Index Funds Work?
Index funds are those types of funds that serve as a theoretical portion of the stock market. Index funds can represent huge or small companies or even those companies that you can segregate depending on which industry they are affiliated with, among others. Index funds are passive investments and include stocks in the process.
Now, because index funds, per se, are not investable in nature, index fund investors can still somehow put an investment through a mutual fund (as this is constructed to “imitate” or to “mimic” the aforementioned index).
With mutual funds, you wouldn’t have to spend much on administrative fees or on fund managers, or merely on shareholder transaction costs. So if you would want to become an investor with a lower expense ratio and become tax efficient, then a mutual fund would work perfectly for you.
ETFs, on the other hand, are considered as investing securities that come in forms of asset baskets. They can be sold or bought any time and any day, as long as an exchange can be made. This is very much different from a mutual fund, because you can only trade at particular hours of the day.
An investment advice professionals would give you on this is that if you want to engage in investing passively, ETFs are a way to go, as they are more knit together to equities and are more liquid when compared to mutual funds.
Choosing Between Index Mutual Funds and Index ETFs
As mentioned numerous times in this article, you can exchange ETFs at any time of the day because they are relatively more liquid than index funds. So, if you would want to actively engage in the market more often, then you should choose using ETFs than mutual funds.
It will be easier for you to choose between an ETF or an index mutual fund as investments after knowing that when you invest in an ETF, you will need to spend it on a brokerage account, a personal finance manager, or a commission share price every time you make a trade. This is very different with mutual funds, as lower operating costs are expected.
Another factor to help you choose between index funds and ETFs is that both are usually being managed passively. The reason behind this is that both try to come up with some match on an index benchmark, rather than to try to outperform it. But if you would want to have relatively actively managed funds, then you can choose investing on some types of ETFs.
Given that you now have more knowledge on the types, differences, and similarities between index funds and ETFs, which do you think suits your financial plans better?
As a conclusion, the very basic and crucial things for you to remember is that, for one, index funds as mutual funds are more fit to those who would like their investments to be less complicated and wait for returns in the long term (such as merely investing on your long term retirement plan). Now if you would want to keep your investments simple and if you would want to minimize your expense ratios, then you will surely benefit with index funds over time.
On the other hand, funds ETFs are more suited for those who would want to keep their investing more hands-on. If you have more diverse investment strategies and would be willing enough to take higher risks, then exchange traded funds will work just right on you. Because of higher risks, you may buy and sell more actively and get capital gains in the short run.
Now, while you can get easily confused with these two major types of investments, all you have to do is remember which fund can easily be traded and which doesn’t, which is better for the long run and the short, among others. If you are looking for more knowledge and pro-tips about Stocks and Funds, just subscribe to our Investoralist’s Newsletter and be ready to equip yourself with the financial knowledge you deserve!