If you've gotten this far, you're already trading pretty smart.
For the modern investor, individual stocks are a gamble. While they can lead to the greatest gains they can also suffer the most unpredictable losses. They're your speculation buy, the boom-or-bust section of a portfolio.
For most investors, funds bring the reliable money. These investment vehicles produce a slower but steady return. They sacrifice the highest highs to smooth out the lowest lows.
Two of the most popular types of funds are the Exchange Traded Fund (ETF) and the index fund. They're occasionally tricky to tell apart, but here are four key differences that you should know before investing.
How ETFs and Index Funds Are Similar
There's a reason that investors discuss ETFs and index funds in the same breath, as both are investment funds. A fund is a collection of assets whose overall value is based on the aggregate performance of its holdings. Some assets may decline while others gain value, and the goal is for overall performance to improve.
Further, both tend to index their investments to a specific industry or benchmark. For example, a fund might be organized to track the performance of the health care industry, precious metals or the Dow Jones Industrial Average.
Indexing is generally considered a passive investment strategy. Instead of searching for the next high-performing asset, fund managers will instead try to hew the fund to its organizing principle. Again, this tends to sacrifice potential high performance investments for a more stable rate of return. This also allows Index Funds and ETFs to operate less expensively than active management mutual funds, as they require less over sight.
ETFs vs. Index Funds
Now, the key differences between ETFs and index funds.
Index funds and ETFs are traded in different ways.
An ETF is traded on a stock exchange like a normal share of stock. Traders can buy and sell shares freely. There is no minimum purchase. You can buy as little as one share or as many as you can afford. This also means that you can typically buy an ETF on your own through an online trading platform.
Unlike an index fund, however, you must buy an ETF in whole shares. The price per share is the minimum unit of purchase, while an index fund will often allow investors to purchase portions of a share in a metric known as the "minimum cost to add."
An index fund is typically sold through a mutual fund broker. This means that the rules for trading vary from vendor to vendor. However, many, if not most, mutual fund brokers require a minimum investment to buy into a position. For example, the Vanguard Prime Money Market Fund (VMMXX) requires a minimum investment of $3,000, while the T. Rowe Price Equity Index 500 Fund (PREIX) requires a $2,500 buy-in.
An index fund may also require notice before selling off your position, meaning that it can be either impossible or expensive to sell an index fund quickly.
This isn't always the case. Minimum costs and liquidation are at the discretion of the brokerage firm, and no-minimum/no-fee funds have become increasingly popular as more retail investors have begun buying into funds.
2. Net Asset Value
The spot sale aspect of an ETF can sometimes affect the prices at which you sell.
With an ETF, like a stock, your sale price is fixed at the time of sale. If you liquidate your position for $22 per share, that's the money you receive. You can sell immediately and even day trade an ETF if you so choose.
Index funds, like mutual funds, work differently. They use a system called Net Asset Value to set the price per share of a portfolio. The value of a fund isn't calculated until close of the trading day when this Net Asset Value is assessed.
At this point the fund processes all trading orders given during the business day. This means that your shares may sell for a different price than the one you saw during the day, for better or worse. It also means that trading is illiquid. You cannot trade intra-day.
3. Fees and Expenses
ETFs and index funds can charge fees in slightly different ways. Here are the main forms:
Since ETFs are bought on a stock exchange you will typically have to pay a commission or broker's fee. This is the same fee you would pay when buying any shares of stock. This commission does not apply to index funds, which are bought through mutual fund brokers. That said, there is a growing number of commission-free ETFs which can be bought and sold without cost.
For long term investors this becomes particularly relevant when rolling over dividends. A typical index fund will roll over dividends for free or automatically. With an ETF you will need to purchase additional shares.
While more common with mutual funds than index funds, "load" is an up-front commission charged when you purchase a fund. It is essentially the commission charged by the broker, typically expressed as a percentage of purchase.
It is uncommon, but not unheard of, for this to be a significant factor in purchasing an index fund.
This is the money that a fund charges for its management and operation. While we discuss expense ratios in greater detail in our article on ETFs here, they are a percent of your fund's assets that the management withdraws to pay its costs.
Typically, expense ratios are lower for an ETF than an index fund.
Taxation is the final significant difference. As a general rule, ETFs are considered a tax-advantaged asset over an index fund. (Both, however, are better than an actively-managed mutual fund.)
The reason is in how liquidation works.
When you sell your shares in an index fund you sell them back to the fund itself. To get the money to buy those shares from you, the fund sells stocks from its portfolio. (This is part of the reason that index funds have rules that restrict liquidation.) This gives it capital, which it in turn pays you.
This causes an index fund to constantly sell and buy shares of stock as investors exit and enter positions in the fund. Each sale of stock is considered a taxable event for the entire fund. Everyone holding shares incurs a tax bill whenever someone sells their shares.
That tax event happens even if the fund overall is losing money. It is in addition to the tax event you incur when selling your own shares in the fund and collecting any profits.
An ETF doesn't have this liability. You liquidate your position by simply selling shares on the open market. This means that the fund incurs no investor-facing internal tax events. You pay taxes once, on any money you make selling your position.