ETF Vs Index Fund: How Do They Compare?

All index funds and the majority of ETFs use the same strategy: passive index investing. This approach seeks to passively replicate the performance of an underlying index rather than beating it, providing easy diversification and sustainable long-term returns.

Diversification

Index funds and ETFs provide a simple way to diversify your portfolio. Both offer exposure to hundreds or even thousands of securities, depending on the index they emulate. This can greatly decrease the likelihood your portfolio will be adversely impacted by big market swings.

Prices of individual stocks may swing wildly day to day, but the ASX loses or gains less than 1% per day, on average. Investing in an index fund or an ETF that tracks the ASX 200 doesn’t protect you from all or any losses, but it does reduce the risks and volatility you’d experience if you only held a few individual stocks.

Sustainable Long-Term Gains

Broad-based, passively managed ETFs and index funds have outperformed actively managed funds over the long term.

An elite minority of active managers may deliver impressive results over shorter periods of time by picking individual securities, but it’s exceedingly rare that they can sustain a winning record over decades. In fact, over the past 15 years, more than 87% of actively managed funds have underperformed their benchmarks, according S&P Global.

What does that mean for your investment in an index fund or ETF?

Over the past 10 years, the ASX 200 has earned an average total return of 9.3% each year. By buying into the ASX200 or other equity index fund, your investments are set to grow over the long term.

Low Fees

Index funds and index ETFs generally have much lower expense ratios, or fees, than actively managed funds. The US Investment Company Institute’s latest survey of expense ratios looked at the average expense ratios of actively managed equity mutual (managed) funds versus index equity funds and index equity ETFs and found:

• Actively managed equity mutual funds charged an average of around 0.74%.
• Equity index funds charged an average expense ratio of 0.07%.
• Equity index ETFs charged an average expense ratio of 0.18%. (It’s not uncommon to see index ETFs with much lower expense ratios, though.)

While they may seem insignificant, expense ratios can really eat into your total returns over time. Assuming you invested $6,000 a year for 30 years and saw an average annual return of 6%, investing in the average index managed fund would save you almost $US60,000 over the cost of the average actively managed fund.

Indexed passive investing reduces your overall costs and leaves more of your money at work in your portfolio.

Related: Best iShare ETFs for Australians

One of the most significant differences between an index fund and an ETFs is how they trade. Shares of ETFs trade like stocks; they’re bought and sold whenever markets are open. While you can order index fund shares whenever you wish, share purchases only happen once a day, after the markets close. This means that the price of any given ETF fluctuates throughout the trading day, while the price of an index fund only changes once a day.

Trading Fees

While both index funds and ETFs charge low expense ratios, additional fees beyond the expense ratio can differ.

As ETFs are more flexible, you may find that you are paying higher brokerage fees for the convenience of frequent trading, whereas with index funds you are able to avoid brokerage fees altogether.

Minimum Investment Amounts

Many index funds have minimum investment requirements, sometimes in the thousands of dollars. ETFs have much smaller minimum investments—often as low as $500.

While some index fund providers have lower minimums if you set up regular contributions, they can still be substantial.

Fractional Shares

Until recently, most ETFs were not available as fractional shares (depending on your brokerage, they still might not be). Index funds, on the other hand, have always been available in fractional amounts.

When you buy into an index fund, managers convert the dollar value of your investment into the correct number of shares based on the NAV the day of your purchase, regardless of whether you end up with a fractional share or not.

Fractional shares have the potential to help you get your money in the market sooner by letting you buy parts of full shares of funds instead of purchasing full, pricier shares. This also lets you better take advantage of dollar-cost averaging, which may help you pay less per share overall over time.

Tax Implications

ETFs are usually more tax efficient than managed funds, and, generally speaking, attract lower capital gains tax (CGT) compared to actively managed funds, which are traded more frequently. While you will pay capital gains taxes on any gains you realise when you sell shares of an index fund or an ETF, you do not pay taxes when the holdings in the ETF portfolio are adjusted by managers. In fact, tax efficiency is one of the big draw cards of ETFs.

Index funds, meanwhile, must buy and sell assets to adjust their portfolio to track the underlying index. The cost of any capital gains taxes from these sales are taken out of the fund portfolio NAV, which impacts the value of your index fund shares. You may face additional tax liabilities when other investors sell out of index funds.

In either case, speak with your accountant or financial advisor for more details on how tax, including capital gains tax, applies to ETFs and index funds as this is a complicated area.

In the end, the choice of ETF vs index fund is probably less important than the fact that you’re decided to invest for your long-term goals using a passive investing vehicle. Whether you choose an index ETF or index managed fund, you’ll benefit from lower fees, diversification and historically superior performance of index-based investing.

You can read more in our guide to managed funds in Australia.