Exchange-Traded Funds (ETF) and Index Funds get interchanged most of the time. The main reason is that these two have almost similar functions. Still, while both of these funds share many things, there are some key differences as well.
If you're a beginner in investing, understanding the difference between ETF and Index Fund is essential. This way, you can evaluate which one is right for you, according to your terms.
Let's take a look first at the similarities both funds offer:
ETF and Index Fund: The similarities
As I said earlier, there are three things that both ETF and Index Fund offer. These are diversification, low-cost investments, and strong long-term results. Let's take a look at each of these.
If you have no idea what diversification means, it's merely a technique that reduces risk by allocating shares or investments among different financial categories.
In simple terms, with both ETF and Index Funds, your investments get placed in a variety of stocks. It runs like this instead of putting it in just a single one.
Further, doing so makes your share secure. It means that if one of those stocks went down, you have shares in other 'baskets,' so you're not entirely at a loss.
ETFs, like Index Funds, run passively. It is unlike many mutual funds, which needs an expert for active management.
For this reason, the fees that experts ask will get slashed when you turn your face to either the ETF or Index Fund.
Both ETFs and Index Funds are the best choices for long-term investors. The reason is that passive management tends to outperform actively-managed mutual funds. Since both follow an index, the indexes show positive returns.
Now, let's look at the differences between these two funds.
ETFs vs. Index Funds: The Key Differences
Although ETFs and Index Funds share many similar things, there are a few differences between them.
These differences can be a factor that will help you choose which one is best for you.
How they are bought and sold
In simple terms, this fundamental difference means that ETFs are tradeable throughout the day like stocks. On the other hand, index funds can only be bought and sold at a price set at the end of a trading day.
For this reason, your best choice will be Index Funds if you're planning for a long-term investment. Getting ETFs for long-term investments will just be some sort of temptation for impulse buying and selling since your shares are tradeable almost all the time.
Now, if you're interested in day-to-day trading, ETFs will be your best option.
Minimum required investment
ETFs will have a much lower investment than index funds. For this reason, if your concern is the shortage of funds for investment, ETFs will be a better option.
For index funds, you will need an average of 2500-3000 dollars at a minimum to have a share in the index funds.
Thus, it comes down to how much you can put into such funds for investing.
Taxes you pay from profits
ETFs have the upper hand when it comes to efficiency in tax than index funds.
When you're selling an ETF, you're selling it to another investor who's buying it, and the cash is coming directly from them.
On the other hand, getting cash out of an index fund means you redeem it from the fund manager, who will have to sell securities to generate some money to pay you.
The net gains get passed on to every investor with shares in the fund. Thus, you could owe capital gains taxes without ever selling a single stock.
In the end, choosing between ETFs and Index Funds boils down to preference. If you're someone who plans for a long-term investment, you can hardly go wrong by choosing index funds.
Now, if you're interested in the day to day trading and changes in the stock value, going for an ETF is your better option.