Index fund versus ETF: what are the biggest differences?
Are you unsure whether it is smarter to invest in an index fund or an ETF? On this page you can find the most significant differences between ETFs and index funds. We will then discuss which investment option is better.
What are ETFs?
ETFs are funds that track an index and are freely tradable on the stock exchange. You can trade ETFs with an online broker. In this article, you can read in more detail how an ETF works.
What are index funds?
Index funds track an index, but they are not freely tradable on the stock exchange. You often buy index funds directly from the provider.
Difference 1: tradability
The first major difference between ETFs and index funds is the level of tradability. ETFs are traded directly on the stock exchange, creating a market of supply and demand. This allows you to sell your shares at any time of the day at the prevailing price. Because ETFs are traded on the stock exchange, the price is also 100% transparent at any time of the day.
With index funds, this works differently. You can usually only sell an index fund once a day, excluding active trading. The price data is also typically updated once a day.
ETFs, therefore, have the advantage of flexibility: you can time the purchase or sale of a fund very specifically using limit orders.
Difference 2: buying fractions of a fund
An ETF is almost always traded at a certain price, and you can indicate how many you want to buy. If the price is $20, and you would like to invest $30, in this case, you can only buy one participation in the ETF.
This works differently for investment funds: you can invest in fractions here. Therefore, you would be able to invest the entire amount of $30.
It is also easier to invest small amounts periodically within an investment fund. For example, you can deposit $100 monthly or weekly into the fund. This is not possible with an ETF, and therefore you have to set up a new order every time.
Difference 3: cost structure
The management costs of ETFs and index funds are often the same, especially when you look at the larger funds. These costs are on average around 0.5%.
However, the purchase and sale costs between index funds and ETFs can differ greatly. Because you buy ETFs from a broker, you typically pay fixed transaction costs. This can make it less attractive to invest in an ETF with small amounts.
With many index funds, you do not pay any costs when depositing money. This allows you to invest periodically in an index fund with small amounts.
Another advantage of index funds in terms of costs is that they can typically handle dividend leakage better.
Is there a difference in return?
There is no difference in return between ETFs and index funds. Both investment products aim to track the index as accurately as possible. The so-called tracking error is minimized as much as possible (this is the difference between the actual index and the price of the investment product).
Of course, this does not mean that the returns between different ETFs and index funds do not differ. Each index fund and each ETF is unique: therefore, research them well before investing.
Are ETFs or index funds better?
There is no absolute answer to this question: which type of investment is better for you depends entirely on your personal situation. It is important to remember that ETFs and mutual funds are very similar, as they both follow indexes and thus aim for average returns. Both investment products are therefore suitable for building wealth in the long term.
Investors who prefer ETFs often point to their higher degree of flexibility. With one broker account, you can invest in funds from thousands of different parties. You can buy or sell your shares at any time, and transparent pricing allows you to know how your investments are performing at any given time.
On the other hand, investors prefer index funds because of their convenience: you can typically automatically invest a periodic amount without looking at it.
Which type of investment fund do you prefer? Please let us know in a comment below the article!
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