ETFs vs Index Funds: The Best Option for Beginners and Pros

ETFs vs Index Funds
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Do you want to know if exchange-traded funds (ETFs) or index funds are a better investment for you? The reality is that they have more in common than differences, but there are a few factors to consider. But for the most part, by the end of this article, taking a look at ETFs vs Index Funds should help you come to a conclusion    

ETFs vs Index Funds Similarities

ETFs and index funds are similar in that they combine multiple individual assets into a single investment. Oftentimes, these assets could include bonds or stocks. They’ve become common among investors for a few reasons:

Low Costs

Index funds and exchange-traded funds (ETFs) are passively managed, which means the fund’s assets are dependent on an index, which is a subset of the wider investing market. As opposed to an actively managed fund (such as many mutual funds), where a human broker actively chooses the investments to make. In this case, the investor pays more in the form of expense ratios. While there are a few actively managed ETFs, we’ll be focusing on the more popular passively managed variety for this comparison. In 2018, the average annual expense ratio for passive funds was 0.15 percent, while those for active funds was 0.67 percent.

Diversification

A well-diversified portfolio can be built with only a few index funds or exchange-traded funds (ETFs). An ETF focused on the S&P 500, for example, would give you exposure to hundreds of the country’s largest corporations.

Strong Long-term returns

Passively managed index funds often outperform actively managed mutual funds for long-term investors. Basically, passively managed investments depend on the liquidity and volatility of the indexes they’re tracking. If you play your cards right, they’ve got the capability of yielding really great returns.    The S&P 500, for example, has averaged about 10% annual total return over the last 90 years.

Either way, fund managers make investment decisions based on current market conditions and their own experience, so actively managed mutual funds may outperform in the short term. However, the likelihood that fund managers can make clear, market-beating decisions over time — not to mention the higher cost ratios — will result in lower long-term returns than actively managed funds.

ETFs vs Index Funds Differences

Although ETFs and index funds share many of the same advantages, there are a few differences to be aware of.

The manner in which they are purchased and sold

The most significant distinction between ETFs and index funds is that ETFs can be exchanged like stocks during the day, while index funds can only be purchased and sold at the end of the trading day.

This isn’t a major problem for long-term investors. Buying or selling at noon or 4 p.m. is unlikely to have a significant effect on the investment’s value in 20 years. ETFs, on the other hand, is a better option if you want to trade intraday. Despite the fact that it is possible to trade them like bonds, investors can still profit from diversification.

But the most important takeaway is that both ETFs and index funds are excellent long-term investments, but ETFs enable investors to buy and sell during the day. In the long run, ETFs are generally a less riskier choice than buying and selling individual company stocks, despite the fact that they trade like stocks.

The required minimum investment

ETFs also have lower minimum investment thresholds than index funds. Most ETFs only require the sum required to purchase a single share. And some brokers, such as Robinhood, go as far as selling fractional shares.

On the other hand, when it comes to index funds, brokers often impose minimums that are significantly higher than the average share price. Vanguard, for example, requires a $3,000 minimum initial investment for most of its index funds, while T. Rowe Price requires a $2,500 minimum initial investment.

There are, however, online brokers that do not need a minimum initial investment. Consider two options if you only have a small sum to invest: an ETF with a share price you can afford or an index fund with no minimum investment amount. Also, ensure that your brokerage doesn’t have an account minimum that you can’t reach, even though many brokers already have zero account minimums.

The Capital gains Taxes you’ll pay

Due to the structure of ETFs, they are naturally more tax-efficient than index funds. When you sell an ETF, you’re usually selling it to another investor who is interested in buying it, and the money comes from them. You are solely responsible for paying capital gains taxes on the transaction.

On the flip side, to get your investment out of an index fund, you typically redeem cash from the fund manager, who will then have to sell shares to raise the cash to pay you. When a sale results in a profit, the net profits are distributed to all investors who own stock in the fund, which means you could owe capital gains taxes even though you never sell a single share.
This occurs less often with index funds than with actively managed mutual funds (where buying and selling occurs more often). But ETFs usually outperform index funds in terms of taxation.

The price of keeping them

From a cost ratio standpoint, both ETFs and index funds can be very inexpensive to own.

As of this writing, both Schwab’s Broad Market ETF and Vanguard’s S&P 500 ETF have cost ratios of 0.03 percent, implying that for every $1,000 invested, you’ll pay only 30 cents a year. Vanguard’s Total Stock Market Index Fund Admiral Shares has an expense ratio of 0.04 percent, while Schwab’s S&P 500 index fund has an expense ratio of 0.02 percent.

Trading commissions are another cost to consider. If your broker charges a commission for trades, you’ll be charged a flat fee any time you buy or sell an ETF, which might eat into your profits if you’re a frequent trader. However, some index funds charge transaction fees when you purchase or sell them, so compare costs before deciding.

Furthermore, when purchasing ETFs, you’ll also pay a fee known as the bid-ask spread, which you won’t see when buying index funds. When purchasing high-volume, wide market ETFs, however, this cost is often minimal.

Final Thoughts

As opposed to most actively managed mutual funds, index funds and ETFs are also low-cost alternatives. To choose between ETFs and index funds, compare each fund’s expense ratio first since this is an ongoing cost you’ll pay for the duration of your investment. It’s also a good idea to look at the commissions you’ll have to pay to purchase or sell the investment, but these costs are typically minor unless you buy and sell often.

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