Introduction:
There are strengths, weaknesses, and better strategies for the use of both index funds and exchange-traded funds (ETFs). They are similar in many ways and are used interchangeably by some people, but “index funds” typically refer to index mutual funds, while “ETFs” can refer to any type of exchange-traded fund regardless of its portfolio, objectives, or fee structure.
What is the difference between ETFs and index funds?
Fund Management Style:
While ETFs can come in a wide range of styles, both index funds and ETFs fall under the term “indexing.” Both involve investing in an underlying benchmark index. The main reason for investing in the index is that index funds (whether ETFs or index mutual funds) can often outperform actively managed funds over the long term.
Unlike funds that are actively managed, indexing relies on what the investment industry refers to as a passive investment strategy. Passive investments do not aim to outperform the market or a specific index, which eliminates the manager risk – the risk or inevitable event that a fund manager makes a mistake and ends up underperforming a particular index.
An actively managed fund may perform well in the early years. It achieves above-average returns, attracting more investors. Then the fund’s assets grow significantly to be managed with the same efficiency as in the past, and returns begin to shift from above average to below average.
Expense Ratios:
Passive investments like index mutual funds and ETFs have very low expense ratios compared to actively managed funds. This is another hurdle that active managers must overcome, and it is difficult to do so consistently over time.
Many index funds have expense ratios of less than 0.20%, and index ETFs can have even lower expense ratios, like 0.10%. Meanwhile, actively managed funds tend to have expense ratios nearing 1%.
Low expense ratios can provide a slight boost in returns on index funds for the investor, at least in theory. However, ETFs can have higher trading costs, depending on the broker you use.
Price:
The fundamental difference between these two terms is that “index funds” are typically mutual funds, whereas ETFs trade like stocks, not mutual funds. This impacts the price you pay for the investment.
The price at which you might buy or sell a mutual fund share is not technically a price – it is the net asset value (NAV) of the underlying securities. Regardless of when you execute your trade during the day, your trade executes at the NAV of the fund at the end of the trading session. If the prices of the securities held by the mutual fund rise or fall during the day, you have no control over the timing of the execution. You get what you get at the end of the day, whether that is better or worse.
ETF traders have the ability to place stock orders. This can help mitigate some of the behavioral and pricing risks of day trading. Traders can choose a price at which the trade will execute using a limit order. They can select a price below the current price and prevent losses below that with a stop order. Investors do not enjoy this kind of flexible control with mutual funds.
However, since ETF trading is determined by price movement rather than NAV, it is possible to pay more for an ETF than the total value of the assets held by the ETF. The price of the ETF usually tracks the value of the underlying securities closely, but may not always match exactly.
Which one
What’s Best for You?
ETFs and index funds are similar, but the better choice for you will depend on your trading style.
ETFs might be better for you if…
You trade ETFs during the day, like stocks. This can be an advantage if you’re able to capitalize on price movements that happen throughout the day.
You can buy an ETF early in the trading session and take advantage of its positive movement if you believe the market is trending upwards and want to capitalize on that trend. The market can move up or down by as much as 1% or more on some days. This creates both opportunity and risk, depending on how accurate your direction predictions are.
Index funds might be better for you if…
If you’re not concerned with trying to capitalize on every daily trading opportunity, index funds might be the better choice for you. Trading in ETFs without understanding how they work can leave you vulnerable to additional costs.
Part of the trading aspect of ETFs is the “spread,” which is the difference between the bid price and the ask price of the security. When ETFs aren’t traded widely, the spread gets wider, and the costs of the spread increase.
Jack Bogle, the founder of Vanguard Investments and a pioneer of indexing, questioned ETFs, even though Vanguard offers a large array of them. Bogle warned that the popularity of ETFs is largely driven by marketing from the financial industry. The popularity of ETFs may not be directly tied to their effectiveness.
The ability to trade an index like stocks also creates an allure to trade, which can encourage damaging investment behaviors such as poorly timed frequent trading.
A Choice That Brings Together Both Worlds
The debate between index funds and ETFs doesn’t have to be an either/or question. It can be smart to consider both.
Fees and expenses are the enemies of the index fund investor, so the first consideration when choosing between the two is typically the expense ratio. There might also be certain types of investments where one fund has an advantage over the other. An investor wanting to buy an index that closely reflects the price movement of gold, for example, will likely achieve that goal better using the ETF called SPDR Gold Shares (GLD).
Finally, while past performance is not a guarantee of future results, historical returns can reveal an index fund or ETF’s ability to track the underlying index and thus provide greater investment opportunities for the investor in the future.
Conclusion
Choosing between index funds and ETFs is a matter of selecting the right tool for the job. ETFs may offer lower cost ratios and greater flexibility, while index funds simplify many of the trading decisions that investors must make.
Investors can use both wisely. You might choose to use an index fund as a core holding and add ETFs that invest in sectors as satellite holdings to add diversity. Using investment tools for the right purpose can create a synergistic effect where the whole portfolio is greater than the sum of its parts.
Frequently Asked Questions:
What is a leveraged ETF?
While a standard ETF holds stocks in companies that make up the underlying index, a leveraged ETF contains derivatives that amplify the volatility of the index. For example, QQQ is a popular ETF that tracks the largest companies in Nasdaq. TQQQ is a leveraged ETF that follows the same companies but with three times the volatility. Leveraged ETFs can also be inverse, meaning they move in the opposite direction of the underlying index.
How do ETF dividends work?
From an investor’s perspective, ETF dividends are just like dividends from other common stocks. They will
Source: https://www.thebalancemoney.com/index-funds-vs-etfs-2466395
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