Index funds and Exchange-Traded Funds, or ETFs, are similar in a lot of ways but there are some core differences that if you are really looking to get into the depths of investing, it might be worth exploring.
If you’ve taken the Learn to Invest course, or you are a long time reader of this blog, it’ll come at no surprise to you that I don’t really care which type of investment you choose, as long as you are investing in the first place. But since I get this question from students often enough, let’s dive into it.
What do ETFs and index funds have in common?
Low cost: Both tend to have lower expense ratios than actively managed mutual funds. And many brokerages allow ETFs and index funds to trade commission-free.
Passive management: Both tend to follow a passive investment approach. They aim to replicate the performance of a specific index. And both provide investors with exposure to a diversified portfolio of assets.
Transparency: Both disclose their investment holdings regularly, allowing investors to see exactly which securities are included in the fund's portfolio.
What are the main differences between ETFs and index funds?
Availability: Chances are, your brokerage will allow you to access any and all ETFs available across the market (if they don’t offer ETFs, maybe consider moving on!). This means you have a wide range of choices. With index funds, your options are more limited. Your bank will offer specific index funds as part of their investment options, but they may not offer index funds offered by other banks. And if they do happen to offer those other index funds, it might be more costly to invest in them. The most obvious implications here for investing in index funds are (1) you are restricted to building a 3-fund portfolio unique to your bank, and (2) changing banks could be a challenge as it might require you to sell your investments, resulting in a capital gains tax* Takeaway: ETFs may have an advantage here as these investments are more portable, e.g. can be more easily moved from bank to bank.
Pricing: ETFs are traded like individual stocks. You can buy or sell them at any point during the trading day, almost instantly. This gives you an accurate picture of your price per share when you choose to sell. On the other hand, index fund prices are determined after the market closes. To get the most accurate price possible, it’s recommended you place your sales order right before the market closes. Otherwise, it’s important to note the market experiences fluctuations if you place your order earlier in the day. Takeaway: If you want to get real specific, ETFs provide an advantage.
Settlement Period: While ETFs typically trade instantly, it usually takes about two days for the trades to "settle," meaning you can't withdraw the sales proceeds from your account until this period is over. On the flip side, the settlement period for index funds tends to be shorter, often just one day or sometimes even immediate. This is important in the event you need this money now. But ideally you have an emergency fund in something like a high-yield savings account as a first line of cash access, rather than your investments. Takeaway: Index funds will payout sooner.
Fractional Shares: With index funds, you usually specify the dollar amount you want to purchase rather than the number of shares. This can result in owning "partial shares." For instance, if you're looking to invest $200 into an index fund and each share costs $80, you'd end up with 2.5 shares ($200/$80). With ETFs, many brokerages only allow you to buy whole shares. So, using the same example, you could only invest $160 (2 shares at $80 each), leaving you with $40 unused since you can't buy a fraction of a share. This is largely an annoyance more than anything. With all that said, more and more brokerages are offering “fractional share investing” as a feature when buying ETFs. Takeaway: Index funds, as you can designate an exact dollar amount and you are not required to do any extra calculations
Minimum Investment Requirements: ETFs typically have no minimum investment requirements, but investors will need to be able to at least afford the cost of a single share. On the contrary many (but certainly not all) index funds will have minimum requirements. For example, Vanguard’s extremely popular Admiral shares have a $3,000 minimum investment in exchange for lower expense ratios. Takeaway: As many index funds do not have a minimum investment requirement, there is rarely a major advantage here.
Asset Specification: Unlike individual stocks or ETFs, where investors can select the specific shares they want to sell (known as "specific lot identification"), index fund investors generally have less control over which specific securities are sold when they decide to redeem their shares. Instead, index fund redemptions typically default to a "first in, first out" (FIFO) method, where the oldest shares purchased are the first to be sold. This lack of control over specific share selection could result in less favorable taxes. Sometimes banks will let you work around this if you call them to reset the default settings to something like selling shares with the lowest or highest cost basis (e.g. please sell shares with the largest or smallest gains), but you still can’t really identify specific shares to sell. And it’s a bit more work to make this happen. Takeaway: ETFs give you significantly more control over which shares you want to sell
Restrictions: Trading restrictions, particularly on "frequent" trades, are common with index and mutual funds. For instance, if you offload a bunch of shares from a fund, you're usually barred from jumping back in for around 60 days. But when it comes to ETFs, there's no such limitation on frequent trading. Now, if you're in it for the long haul with your investments (and most folks really should be), these restrictions should not bother you much. But if you are trying to do some more fancy stuff like tax-loss harvesting, this may be annoying. Takeaway: ETFs tend to be more flexible
So there you have it, the core differences between ETFs and index funds. Again, my takeaway is that if your money is invested in low-cost, diversified funds, you’re doing a great job already! For what it’s worth, I have both ETFs and index funds, where my entire regular brokerage account is made up of ETFs and my retirement portfolio is index funds.
Drop my a line if you have your own unique strategy!
P.S. You may have noticed I didn’t mention taxation above. Both ETFs and index funds are tax-efficient, but many argue that ETFs are more so than index funds and thus you should be sure to include them in your regular brokerage account. To me this is splitting hairs, but if you want to read more about this philosophy you can do so here.
Notes:
*Vanguard does offer an ETF Conversion Program to switch holdings from specific Vanguard mutual funds to equivalent Vanguard ETFs without incurring tax consequences.
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