If you are new to investing, you have likely come across a variety of investment types. With stocks, bonds, funds, commodities, and more available, how are you supposed to know what the best investment is?
INCOME.ca is here to help you figure it out! In this article, we’re going to discuss index funds and ETFs (exchange-traded funds). As they both have the word “funds” in them, some people get confused about their difference.
So, we’ll discuss the similarities, differences, pros, and cons of each type of investment. We will also try to help you decide what the best type of investment is for you. If you are interested in these types of investments, keep reading!
What Are Index Funds and Index ETFs?
An index fund is a type of mutual fund that is constructed to match or track a financial market index’s performance. An example of this is the SP 500 Index. Index funds tend to be a lower risk than investments in securities like stocks. Investors will use index mutual funds to build a diverse portfolio. They are also cheap to operate and tend to be a passive way of investing.
On the other hand, exchange-traded funds (ETFs) also gives you access to a collection of securities. ETFs tend to include a mixture of stocks, commodities, and bonds. They are similar to mutual funds, but ETFs trade like stocks.
ETFs can invest in a variety of sectors, such as energy (see this post), real estate, gold, technology, or banking – see ‘Best Canadian Bank ETF’ here. ETFs can either be passively managed or actively managed. Actively managed ETFs tend to have a higher expense ratio.
The Difference Between Index Funds and ETFs
One of the main differences between index funds and ETFs is how you buy and sell each. Since ETFs trade like stocks, you can buy and sell them throughout the day. Index funds, however, can only be bought or sold at the end of the trading day.
Another one of the differences between ETFs and index funds is the minimum investment required for both. ETFs tend to have a lower minimum investment. This is because the minimum requirement tends only to be the price of a single ETF. For index funds, brokers tend to charge a minimum initial investment. The minimum investment required can be as high as $3,000. So, ETFs tend to be the better option for new investors.
The last of the differences between ETFs vs index funds is the cost it takes to own both. ETFs tend to have a lower cost and are more tax-efficient as well. Fees such as commission fees or transaction fees tend to be lower with ETFs, so investors will end up saving more with ETFs.
Ultimately, ETFs tend to be cheaper, more tax-efficient, have a lower minimum investment, and can be bought or sold at any time during the trading day.
Similarities Between ETFs Index Funds
The main similarity between ETFs (see the best ETFs in Canada here) and index funds is the diversified portfolio you can get with both. ETFs and index funds both bundle together individual investments in other securities like stocks and bonds (see also bond ETFs). Thus, when you purchase ETFs or index funds, you get access to many companies.
ETFs and index funds also tend to be the cheapest type of investments. They are both typically passively managed, so you are not paying someone to manage your funds. There are actively managed ETFs, but they are less common and have higher expense ratios. The expense ratio for index funds is usually below 0.20%, and for ETFs, it is usually only 0.10%. Actively managed funds, however, typically have an expense ratio above 1.00%
Both ETFs and index funds are also great for long term investors. As they are passively managed, they can be left to their own devices to earn money for investors over time.
ETFs, index funds, and index mutual funds fall under the category of indexing. This is a strategy of investing where investors invest in an underlying benchmark index. Indexing relies on passive investments, which, as we discussed, are better for long term investors.
Choosing Between Index Funds and ETFs
Pros of Index Funds
- A low-risk option for investing in stocks and bonds.
- Great return for investors looking for a longer-term investment.
- Investors can create a diversified portfolio as index funds represent various sectors, such as real estate or technology.
- Index funds offer lower fees than non-index funds.
- Investing in an index fund is a passive investment rather than an active one. This means you can let your investment sit and do the work for you. You won’t need to pay someone else to track the performance or invest for you.
- More tax-efficient than other investments such as mutual funds. This is because they don’t produce capital gains.
- You don’t need to be as concerned with market swings when investing in an index fund as you are in it for the long haul.
- You also don’t need to worry about when the best time to buy or sell is. Your diversified portfolio does not rely on the best market timing.
- Even beginner investors can invest in an index fund as it is an easy and reliable investment.
Pros of ETFs
- ETFs are a great low-risk investment and often used as an alternative to investing in a mutual fund.
- You can build a great, diversified portfolio by investing in ETFs. With ETFs, you can invest in bonds, stocks, and commodities rather than just investing in one thing.
- Easy to trade as they trade like a stock rather than a mutual fund.
- Passively managed ETFs have lower fees than other investments as you don’t need to pay a broker to help you invest.
- ETFs can be traded at any time during the trading day, not just at the end.
- ETFs are more tax-efficient than other types of investments, such as mutual funds. This is because ETFs realize fewer capital gains.
- ETFs are transparent as you can see what’s inside their portfolios.
- You can invest in different sectors with oil (see best oil ETFs here), technology, gold, silver, etc.
- There is no minimum requirement for how much you have to invest in an ETF.
- ETF shares are great for both long or short term trading. Like most investments, you will earn more in the long run with an ETF, but it can still be a good short term investment.
Cons of Index Funds
- Investing in an index fund is not a good investment for those looking for something short term.
- Although index funds tend to be safer than other investments, such as mutual funds or stocks on their own, they are not a guaranteed investment.
- You cannot buy and sell index mutual funds whenever you want; you have to wait until the end of the trading day.
- Similar to mutual funds, you cannot pick your preferred stock with an index fund (see also ‘Best Preferred Shares Canada’ here). You are buying a bundle of stocks and bonds, so you may end up with one you don’t like or have a poor performance history (see also undervalued stocks).
Cons of ETFs
- You can not reinvest ETF dividends without paying broker commissions.
- As ETFs are easy to trade, investors may overtrade them and end up losing money.
- ETFs, incur the same brokerage fee as stocks unless you use a no-fee brokerage.
- ETFs tend to be passively managed, so investing in them can be hard for beginner investors.
- Dividend yields tend to be lower with ETFs compared to investing in stocks.
- International ETFs are limited.
- As ETFs have low volatility, they are not the best investment for short-term investors looking for big volatility changes.
Should You Use Index Funds, ETFs, or Both?
Now that you know more about an ETF vs an index fund, you may be wondering which is the best option for you. Both are great options for investors looking to invest in the long run (see ‘How to Trade Options in Canada‘). Similarly, they are both great at providing investors with a diversified portfolio.
Neither is great as a short term investment, but both can produce great results over a longer period of time.
As they are both similar investments, choosing one can be difficult. That being said, ETFs may be the slightly better choice. ETFs, provide investors with the freedom to buy or sell whenever they want to or need to. They also tend to be cheaper and more tax-efficient so that you will be saving even more in the long run.
The only minimum investment with ETFs is that you can afford to buy the exchange-traded fund. With an index fund, brokerages tend to charge a high minimum fee to invest, sometimes as high as $3,000.
Ultimately, investing in either type of investment can be beneficial. You will get a great, diversified portfolio that will be passively managed. You can invest your money and watch it grow over time with either investment.
The Bottom Line
Every investor has different needs, goals, and financial situation. Due to this, it can be hard to decide what the best investment is for you. One investor may have huge returns from mutual funds, while another may have experienced losses from them. If you are looking for low-risk, diversified portfolios, though, index funds and ETFs are prudent investments to make.
With both investments, you have the potential to earn a profit over time with relatively little risk. They are both passively managed investments, so you need to invest and (hopefully) watch your money grow. Passively managed investments tend to be more beneficial than actively managed ones as you won’t have to pay a management fee.
Choosing between the two investments can be hard since they are so similar. But, ETFs do have a slight advantage. You will be able to buy or sell them whenever you want during the trading day, while index funds can only be traded at the end of the trading day. Similarly, ETFs are typically cheaper and more tax-efficient. This will help you save money in the long run.