Busy professionals who don’t have the time to pick individual stocks have the option to invest in passive funds that track indices. This can give investors exposure to a whole index worth of stocks.
Exchange Traded Funds (ETFs) and index funds fall under the category of passively managed investments. But wait… ETFs can be bought and sold like stocks but index funds can’t.
Both ETFs and index funds have “fund” in their name. Then why exactly are they so different? Let’s find out by going through both index funds and ETFs in greater detail.
What Are Index Funds?
Index funds are mutual funds that generally track an index like Nifty, Nasdaq, or FTSE. They’re passively managed mutual funds that have a portfolio with multiple securities.
The fund manager of an index fund will build a portfolio of stocks or bonds that mirror an index. After that, the fund manager will simply leave the index fund as it is to track the index and mirror the returns.
The implication of trying to mirror and track an index is that index funds don’t outperform the market. They logically cannot do that as they are mirroring an index to a tee.
What Are Exchange Traded Funds (ETFs)?
Exchange Traded Funds (ETFs) are a collection of securities that can be bought and sold like stocks on a stock exchange. This is a stark contrast to index funds whose NAV is calculated at the end of the day.
ETFs can track indices like S&P 500 or precious metal prices like gold bullion. An ETF’s potential to outperform the market is rare but it’s not entirely out of the question.
Are There Similarities Between Index Funds And ETFs?
We’ve reached an inflection point, that is, if you’ve read the definition of index funds and ETFs carefully. The similarities between index funds and ETFs is greater than the dissimilarities. Here’s how:
Index funds and ETFs are a basket of securities - stocks, bonds, mutual funds, ETFs - that track a specific index, sector, or entity.
Index funds and ETFs help you diversify your portfolio drastically as they’re a collection of securities, all in one investment.
3. Investment Cost
The expense ratio of passively managed index funds and ETFs tends to be relatively lower than actively managed funds. By association, the investment cost of index funds and ETFs is comparatively low as well.
That’s because passive funds don’t have a team of analysts or an active fund manager constantly trying to analyse and outperform the market.
Index funds and ETFs have been known to generate solid long term returns. They tend to mirror the index they’re tracking and as a result, grow with the market. The returns are known to range from 10-15% over 5+ years.
Index Funds Vs ETFs
There are a few differences between index funds and ETFs that have wider implications on the overall desirability of both investments.
1. Mode Of Investment
Index funds are mutual funds, as discussed before. This means they can be bought or sold at the NAV price that’s calculated at the end of each day. ETFs are different - they are traded like stocks.
2. Minimum Investment Amount
On average, it would cost less to invest in an ETF for the first time compared to an index fund. You can buy a single ETF or even a fractional ETF just like a share.
An ETF’s cost in India, for example, can range from anywhere between ₹15 to ₹20,000. Index funds, on the other hand, can cost a minimum of ₹100, ₹500, or ₹1000 depending on the broker.
Index funds are generally equity investments. ETFs can be equity, debt, gold, or international investments. That’s why they’re taxed differently.
What’s Best For Investors: Index Funds Or ETFs?
By this point, you may have understood that index funds and ETFs have more things in common than not. But the jury is still out on what’s best because that would depend on the type of investor you are.
In general, index funds and ETFs are known to be suitable for passive investors like busy professionals who don’t have the time to research individual stocks.
Index funds and ETFs help them gain access to a diversified portfolio of securities in one asset. Moreover, the returns are fairly similar as well so it all boils down to the expense ratio and commission fees.
You must note that ETFs are prone to something known as a bid-ask spread. The bid-ask spread is relatively small when it comes to ETFs. Spread, in finance, means the difference between two prices.
Here, it means the highest price a buyer is willing to pay versus the lowest price a seller is willing to accept. This may lead to liquidity concerns. You won’t encounter a bid-ask spread with index funds.