ETF’s Versus Index Funds & the 5 Big Differences to Consider

ETF’s or Index Funds: An Epic Battle

ETF’s (exchanged traded funds) and index funds. The comparison between the two is kind of like deciding to pull over to a restaurant that you see off the side of a road in a region of the country you’re not familiar with. If it’s called ‘Marco’s’, the chances are that it’s Italian and it has some pasta, marinara, alfredo, and garlic bread inside. In much the same way, if you see an index fund and an ETF that track the S&P 500, you can reason that each is going to have some large, well-known U.S. based corporations inside.

However, since you’ve never eaten at ‘Marco’s’, you’re not sure what type of dining experience awaits, how much it will cost, or what kind of gastric issues you’ll have afterwards. These differences are going to take a bit further explanation.

Differences Between Index Funds and ETF’s

1. How they Trade

  • etf versus index fundIndex Funds: Index funds are a type of mutual fund. You purchase shares from the fund management company. Index funds do not trade on the open market throughout the day. Share purchases can only happen once a day – at the close of trading.
  • ETF’s: Shares are purchased through a broker and are traded on the market throughout the trading day.

2. How they are Priced

  • Index Funds: Are based on the fund’s holdings rather than a perceived value of that fund. Shares are priced based on their Net asset value (NAV), the same way all mutual funds are. Net asset value is (assets-liabilities)/shares outstanding.
  • ETF’s: NAV is used to evaluate the ETF by investors and market forces (supply and demand) influence the share price through trading. When an ETF’s share price trades at too much of a premium or discount to it’s NAV, savy investors will typically come in to purchase or sell their shares, often-times bringing the price close to the NAV.

3. Cost

  • Index Funds: Cost whatever the broker charges to get into that fund and any loads charged by the fund company, plus an ongoing expense ratio that is typically higher than its ETF counterpart. For instance, while the Vanguard REIT ETF (VNQ) has an expense ratio of 0.10%, the index fund tracking the same index (VGSIX) has an expense ratio of 0.20%.
  • ETF’s: Cost is whatever your broker charges to make a trade (buying and selling) plus an expense ratio that is typically less than its index fund counterpart.

4. Functionality

  • Index Funds: Generally have much less functionality than ETF’s. For starters, when you buy or sell you do it at the NAV price at the end of the trading day (you don’t have an option). If you buy or sell during trading hours, you have no knowledge of what that price is going to be on your trade. Also, funds can be limiting in that many of them have high minimum and subsequent investment amounts when purchasing.
  • ETF’s: Much more functionality. You can make any type of trade that you are able to make with regular stocks, including limit orders, short selling, etc. Meanwhile, you set the price and can trade at any point during the day.

5. Tax Efficiency

  • Index Funds: When you own a mutual fund you are often forced to pay capital gains taxes every tax year, even if you don’t sell any shares. Bummer, right? This is because any taxes are passed on to you when a fund sells a security for a gain.
  • ETF’s: The structure of ETF’s tends to cut down on capital gains taxes that fall on you. However, you may end up paying capital gains taxes when you sell anyways. In general, ETF’s are said to have less of a tax burden, but I couldn’t find any quantifiable data behind this (if you can, please post in comments).

Conclusion on Index Funds Vs. ETFs:

If you’re not sure whether to go with an index fund or its ETF counterpart, your line of thinking should probably go something like this:

  1. Can I even afford to get into the index fund with how much I have to invest? If not, going with an ETF is a no brainer.
  2. Does the index fund provide the functionality I’m looking for (i.e. a short sale). If not, go with the ETF.
  3. Other than that, it is up to you to do an analysis on which of the two options is going to cost you less for how you plan on investing with it. Think about how often you will be purchasing more, how much your broker charges, and compare the expense ratios between the two.

Regardless of which you choose, I personally use and highly recommend TradeKing and Vanguard for ETF trading.

Fund Versus ETF Discussion:

  • Do you tend to prefer index funds or ETF’s? Why?
  • What other reasons, pro or con, have you found for buying index funds and ETF’s?

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