From trading frequency to relative risk profiles, here’s everything you need about ETFs and index funds and the difference between the two.
What is an exchange-traded fund (ETF)?
More commonly referred to as an ETF, an exchange-traded fund is a type of investment product bought and sold on the stock exchange.
An ETF usually contains a collection of stocks, bonds or securities, though there are also single-security ETFs that track just one stock, bond, or commodity.
ETFs are very similar to mutual funds, but unlike mutual funds, which are restricted to one sale a day, ETFs can be bought and sold like common stock multiple times over.
There are both physical and 'synthetic' ETFs available. Synthetic ETFs trade derivatives or ‘swaps’ rather than straightforward assets or securities.
Since their inception, EFTs have become popular among investors, forming an essential element of a diversified, risk-reduced portfolio of assets.
What is an index fund?
An index fund is a collection of stocks, bonds or securities. Index funds passively track the performance of a particular stock market index, such as the S&P 500 or the FTSE 100.
While ETFs are very similar to mutual funds but distinct in their trade rules, index funds are a specific type of mutual fund.
This means index funds are only priced at the end of each trading day. They are distinct from other mutual funds in that they track one index.
Generally speaking, index funds are considered low risk, offering you more comprehensive exposure to the market without simultaneously exposing you to costly investment management fees.
Index funds function ideally when they can sit at the centre of a pot of savings and investments held for, say, retirement.
What are the differences between ETFs and index funds?
As mentioned above, the most significant difference between the two is that ETFs are traded similarly to common stocks, while index funds can only be bought or sold once daily, at the end of trading hours.
This won’t be a problem if you’re a longer-term investor, but it may make index funds less ideal for day traders and others seeking short-term wins.
Similarities between ETFs and index funds
ETFs and index funds usually comprise a bundle of stocks, bonds and/or securities.
Both ETFs and index funds come with a low cost of entry and potentially strong long-term returns.
Both ETFs and index funds are a preferred route to diversification for investors of all kinds.
Differences between ETFs and index funds
ETFs can be freely traded throughout the day. Oppositely, index funds can only be traded at the close of each day.
ETFs usually require a lower minimum investment amount than index funds.
ETFs are more efficient in terms of tax liability than index funds because of how the receipt of capital gains is structured.
Another difference between ETFs and index funds is that it is generally easier to determine what an ETF is invested in.
ETFs publish their underlying holdings daily, usually via their website.
Index funds are only required to disclose their top 10 holdings, so it’s much more difficult to find exactly what’s in the fund.
Which is safer, an ETF or an index fund?
Neither an ETF nor an index fund is necessarily safer than the other.
The riskiness of an investment primarily depends on what that investment comprises.
In other words, what does the bundle that makes up the fund in question consist of?
Generally speaking, a fund of either type comprised of stocks will be riskier than a fund of either type comprised of bonds (though that higher risk will often yield a higher return on investment).
With an index fund, your ability to react to a situation might be limited because you have to wait until the end of a trading day to buy or sell.
Beyond this, the risks of ETFs and index funds cover similar ground, as both are affected by market fluctuations and price movements.
Comparing costs for ETFs vs index funds
Both ETFs and index funds come with minimal management â€‹â€‹costs, though they aren’t entirely without fees.
For an ETF, given that they’re traded on the stock market, you may be required to pay a stockbroker fee when you buy or sell.
For example, if you want to trade an ETF in real-time at Vanguard, it’ll cost you £7.50 to use the quote and deal service.
Management fees are often less than 0.4% for index funds, while active mutual funds usually charge upwards of 0.7%.
How do I decide which investment option is right for me?
When choosing between investing in an index fund or an ETF, you should consider:
Your investment goals and what aligns with your broader strategy.
The relative fees associated with ETFs versus index funds, both initial and ongoing.
The relative risk levels and risk types associated with ETFs versus index funds.
The recommendations of a financial adviser who knows your situation well.
If you still have questions and you’re seeking investment advice from an experienced professional, Unbiased can help you find a financial adviser.