ETF or Index fund? Have you ever heard those terms and had no idea what this means? And yet you tried to maintain polite conversation about them. Let me try to explain in very simple words the difference between ETF and Index fund and why you shouldn’t care about it too much.
ETF or exchange traded fund is a security that tracks an index like S&P 500 (stocks), or bonds, or other asset class. It trades like a stock on stock exchange, so their price changes throughout the day and they have higher liquidity.
Index fund is a type of a mutual fund that has portfolio that tracks and matches market index like S&P 500 (stocks), Bond Index, and other asset classes. Index funds implement passive management thus they have low expenses and low portfolio turnover. (If you want more info and a great current day facts on indexing this link offers a very informative article).
So what is the big deal and the difference? Both sound like exactly the same thing.
ETF or Index Fund: differences
Expense ratio – usually lower on ETF but not necessarily. There are plenty exceptions to this rule.
Trading commissions – usually higher on ETF as they are sold like stock. Index funds have advantage of commission free purchases.
Dividend distribution – usually automatically reinvested in Index funds commission free, ETFs have to buy more shares and pay commission for trade.
Difference between ask and bid price – hidden cost of ETFs. Bid is that you are willing to pay. Ask is what the selling price is. Trading ETFs with large spreads between the two can lower returns since it affects ETF purchase and sales prices.
If you are interested in learning more about fee differences there is a great article by Morningstar.
Usually ETFs have lower investment minimums but there are plenty exceptions and affordable Index funds nowadays. And index funds have oftentimes low minimums on add-on investments.
ETFs are generally considered more tax efficient since they rarely sell/buy stock for cash (realize capital gains/losses). However, there are plenty of Index funds that can compete in tax efficiency with ETFs. Good example is Vanguard admiral shares funds.
ETF trades during the day like stock, while Index Funds transactions are usually processed after close. Hence ETFs are more liquid.
Conclusion: does it really matter if we invest in ETF or Index Fund?
With great variety of Index funds and ETFs available, there is no defined rule as to which one has lower fees or offers more savings to average investor. Index funds, though advertised as more costly vs. ETFs might be in fact cheaper and better for average investors. They are low cost and very tax efficient. So if you still unsure what ETF simply don’t buy it. You are just fine with Index funds.