ETF vs Index Fund - What Do You Choose?
If you are familiar with the world of investment, then you may have come across the terms ‘ETF’ and ‘index fund’ before. But do you understand what they are and what the difference between them is?
In this article, we will analyse the difference of an ETF vs index fund, discuss which may be better suited to you and explain how you can start investing in ETFs with Admirals (formerly Admiral Markets)!
ETFs and Index Funds Explained
ETFs (Exchange-Traded Funds) are a type of investment fund which attempts to track an underlying economy, sector or index. It achieves this by investing in a basket of assets, such as stocks and bonds.
Index funds are designed to track the value of a market index, such as the FTSE100 or the S&P 500. In order to achieve this, the fund acquires shares of the companies which its underlying index is composed of and thus mimics that index’s performance.
Straight away, from these simple definitions, we can see some parallels between the two. Both aim to mirror an underlying market and both achieve this by pooling investors money in order to acquire a basket of securities.
This shared quality of investing in a basket of securities offers instant diversification over a large number of securities, which vastly reduces investor risk - an important part of risk management.
Furthermore, we can categorise both as passive investment vehicles, as opposed to an actively managed fund. Passive investments try to track the performance of their underlying market; whereas, actively managed funds attempt to outperform the market. As such, actively managed funds are associated with higher fees as they have higher costs, including expensive fund managers.
It is extremely rare for active funds to beat the market consistently over the long term, which is why passive investment vehicles, with their lower fees, have become so popular.
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ETF vs Index Fund: The Main Differences
Despite the close similarities between these two types of fund, there are some differences in how they operate, which will play a part in deciding which is a more suitable investment for you. In the following sections, we will take a look at a few of these key differences.
1) Types of Market
The first major difference between the two is the types of market which are available for investment.
As the name suggests, an index fund simply tracks a specific underlying market index, such as the FTSE100.
On the other hand, whilst the majority of ETFs are also index based, there are many other types of ETFs which are designed to track other markets or sectors of the economy. For example:
- Commodity ETFs - track the performance of an individual commodity, such as gold or crude oil, or the performance of a collection of commodities, such as precious metals.
- Industry ETFs - track individual sectors of the economy, such as healthcare or real estate
- Currency ETFs - track the value of a basket of foreign currencies
- Bond ETFs - track the performance of a particular bond market
2) How They Are Traded
ETFs are listed on stock exchanges and can be traded throughout the day, much like shares, during the hours the market is open. However, index funds are only traded once the market has closed at which time the price per share of the fund - or more specifically, the Net Asset Value (NAV) - is established and set at this level for investors wishing to enter or exit the fund.
This increased flexibility of ETFs allows traders to enter or exit their position throughout the day to capture any potential positive intraday price movements or, on the other hand, attempt to avoid any negative ones.
Therefore, if you prefer a more hands on trading style an ETF may be more suitable for you.
The fact that ETFs are traded like stocks produces a few knock on differences between an ETF vs index fund, the first of which is liquidity.
Liquidity is the measure of ease with which a position can be converted into cash. Popular ETFs with a high trading volume, will benefit from high liquidity, meaning that you can enter and exit positions easily.
However, unpopular ETFs may suffer from illiquidity, meaning that it may be more difficult to open or close a position This is because with ETFs, as with shares, in order to open a position or to liquidate one, you are reliant on matching with another market participant wishing to make the opposite transaction. If there is no counterparty available, you may end up stuck with an ETF for longer than you wanted.
Index funds, on the other hand, although only possible to enter or exit at market close, do not rely on a counterparty for transactions. Instead fund managers tend to hold a percentage of the total investments in cash in order to liquidate an investors position if they wish to do so.
This can present an issue if too many investors try to liquidate their holdings at the same time, as the fund manager will then need to unwind some of their positions in securities in order to facilitate these requests.
4) Fees and Minimum Investments
In terms of annual management fees, known as the expense ratio, ETFs tend to have a slight advantage. Although, this difference has narrowed in recent years and it depends on the fund in question.
However, due to ETFs being traded on an exchange they are usually liable to a broker’s commission which will vary from broker to broker.
Index funds tend to have a fixed minimum investment amount which is typically upward of $2,000. Although, an increasing number of index fund managers are beginning to offer funds with no minimums. ETFs have no minimum investment requirement, you can buy an ETF for the cost of one share which varies depending on the ETF in question.
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5) Supply and Demand vs NAV
As mentioned above, the price per share of an index fund is known as the NAV and is set at the close of each trading day. The NAV is calculated by dividing the total value of all cash and securities held by the fund, less any liabilities, by the number of shares outstanding.
Thus, the share price of the fund is reflective of the value of that fund at the end of the trading day.
On the other hand, the price of individual ETF shares are determined by market supply and demand and fluctuate accordingly throughout the trading day.
Therefore, if an ETF is so highly sought after that demand outstrips supply, it could temporarily trade at a price which is actually higher than its NAV. Conversely, an unpopular ETF could trade lower than its NAV.
Although this can cause ETF mispricing to occur, it typically only lasts briefly, making it difficult for traders to exploit. This is because ETFs use a redemption mechanism which aims to keep an ETF’s market value and its NAV as close as possible by creating and redeeming shares to correct any imbalances.
6) Tax Efficiency
ETFs and index funds both enjoy good tax efficiency, however, ETFs have the edge. This is because ETFs do not often buy or sell securities. When an investor wishes to unwind their position, they simply sell it on the stock market.
Alternatively, if an index fund investor wishes to liquidate their position in the fund, the fund manager may need to sell securities in order to realise the necessary cash to pay the investor. This more frequent selling of securities results in larger capital gains and their associated taxes for everybody who continues to hold a position in the index fund.
Which Is Best For Me?
Generally speaking, if you prefer lower investment minimums and a more hands-on trading experience, ETFs are likely to be the better choice. However, that is not to say that the opposite is also true.
When it comes to choosing between an ETF vs index fund, there is no ‘one size fits all’ type of answer to the question of which is ‘better’. The smart investor will consider both, as it very much depends on the specifics of the fund in question. As with many investment decisions, the decision will most likely come down to which option is most cost effective.
How to Buy ETFs With Admirals
With an Invest.MT5 account from Admirals, you can buy stocks and ETFs from 15 of the largest stock exchanges in the world! You can get started by following these steps:
- Sign up with Admirals
- Log in to your ‘Traders Room’ account
- Select ‘Open New Live Account’ and select ‘Investing’
- Fill in the requested information which will include contact details, tax information and passport number
- Verify your identity by uploading the requested documents
Once you have finished your application, it will be reviewed by Admirals and you will be notified of the result by email. If your application is successful, you will also receive your account details by email.
In order to invest in your first ETF you will need to:
- Download the world renowned MetaTrader 5 trading platform
- Log in to the trading platform using your account details
- Open the Market Watch tab by pressing Control + M (if it is not already shown on the left hand side) and then press Control + U to open the Symbols window, as shown below. From here, you can search for the ETF you wish to buy, press ‘Show Symbol’ and then click ‘OK’
Depicted: Admirals MetaTrader 5 - Symbols
- Head back to the Market Watch tab and find the symbol which you added, right click on it and select ‘Chart Window’
Depicted: Admirals MetaTrader 5 - Vanguard S&P 500 UCITS ETF Daily Chart. Date Range: 21 January 2020 - 18 March 2021. Date Captured: 18 March 2021. Past performance is not necessarily an indication of future performance.
- In order to invest in the chosen ETF, right click anywhere on the chart, select ‘Trading’ and ‘New Order’. Fill in the type of order you wish to create, the volume and a stop loss and take profit if required.
Depicted: Admirals MetaTrader 5 - New Order
About Admiral Markets
Admiral Markets is a multi-award winning, globally regulated Forex and CFD broker, offering trading on over 8,000 financial instruments via the world's most popular trading platforms: MetaTrader 4 and MetaTrader 5. Start trading today!
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.