ETF vs Index Fund: What's the Difference? (2023)

All index funds and most ETFs follow the same strategy: passively investing in indices. This approach is designed to passively replicate the performance of the underlying index, ensuring easy diversification and sustainable long-term returns.

Diversification

Index funds and ETFs provide an easy way to diversify your portfolio. Both offer exposure to hundreds or even thousands of securities, depending on the index they follow. This can greatly reduce the likelihood that large market fluctuations will negatively affect your portfolio.

Individual stock prices can fluctuate wildly from day to day, but the ASX loses or gains less than 1% per day on average. Investing in an index fund or ETF that tracks the ASX 200 does not protect against all or any losses, but it does reduce the risk and volatility that you would experience if you only owned a few individual stocks.

Long-term, sustainable profits

Wide-ranging, passively managed ETFs and index funds outperformed actively managed mutual funds over the long term.

An elite minority of active managers can achieve impressive results in shorter periods by picking single titles, but they very rarely manage to maintain a winning record spanning decades. In fact, over the past 15 years, over 87% of actively managed funds have performed below their benchmarks, according to S&P Global.

What does this mean for your investment in an index fund or ETF?

Over the past 10 years, the ASX 200 has averaged a total return of 9.3% per year. By purchasing the ASX 200 or any other index fund, your investments are expected to grow over the long term.

low installments

Index funds and index ETFs generally have much lower spend ratios than actively managed funds. Institute of American Investment Firmslatest expense ratio studyanalyzed the average cost ratios of actively managed equity mutual funds compared to equity index funds and equity index ETFs and concluded:

• Actively managed equity investment funds charged approximately 0.74% on average.
• Index funds charged an average cost ratio of 0.07%.
• Stock index ETFs charged an average cost index of 0.18%. (Often, indexed ETFs have much lower spend ratios.)

While they may seem insignificant, spending metrics can eat away at your total ROI over time. Assuming you invested $6,000 per year for 30 years and earned an average annual return of 6%, investing in an average index fund would save you almost $60,000 compared to the cost of an average actively managed mutual fund.

Index and passive investing reduces overheads and leaves more money in your portfolio.

Related: Best iShare ETFs for Australians

One of the most significant differences between an index fund and an ETF is the way they trade. Stocks in ETFs trade like stocks; they are bought and sold when the markets are open. While you can order stocks of index funds at any time, stock purchases only occur once a day, after the markets close. This means that the price of any ETF changes during the trading day, while the price of an index fund only changes once a day.

trading fees

While index funds and ETFs charge low fees, additional fees beyond the spending fee can look very different.

Most brokers have eliminated trading commissions on almost all stock trades, and many also do not charge commissions on ETF trades. Meanwhile, broker commissions on the sale of index funds can be very expensive. That said, online brokers often offer a selection of commission-free funds. There is simply no guarantee that the funds you want to buy are commission-free.

Then there are transfer fees, another form of sales commission. Frontloading fees may be charged for buying funds while backend loading fees may be charged for selling funds. Charging fees can be a percentage of the total purchase or a flat fee. ETFs do not have full reload fees.

As such, a given ETF may charge a higher annual spend fee than the index fund you have your eye on, but you must consider possible commissions and sales transfer fees charged by a comparable index fund.

Minimum investment values

Many index funds have minimum investment requirements, sometimes in the thousands of dollars. ETFs have no minimum purchase requirements.

While some index fund providers have lower minimums, if you regularly contribute to a tax-free retirement account, they can still be substantial.

fractional shares

Until recently, most ETFs were not available as fractional stocks (depending on your brokerage, they still may not be). On the other hand, index funds have always been available in fractional amounts.

When you buy an index fund, managers convert the dollar value of your investment into the appropriate number of shares based on the NAV on the date of purchase, whether you receive a fraction or not.

Fractional shares have the potential to help you get your money to market faster by allowing you to buy shares of a full fund instead of buying the more expensive whole shares. It also allows you to make better use of dollar cost averaging, which can help you pay less per share over time.

Tax consequences

ETFs are generally more tax efficient than managed funds and generally attract less capital gains tax (CGT) compared to actively managed funds, which are traded more frequently. While you pay capital gains tax on any gains made from selling shares in an index fund or ETF, you pay no taxes when the shares in the ETF portfolio are adjusted by the managers. In fact, tax efficiency is one of the greatest advantages of ETFs.

Index funds, on the other hand, must buy and sell assets to align their portfolio with the underlying index. The cost of any capital gains taxes associated with such sales is deducted from the NAV fund's portfolio, which affects the value of its shares in the index fund. That said, index fund holdings rarely change, so this may not be a big deal to you.

In either case, talk to your accountant orfinancial advisorfor more information on how tax, including capital gains tax, applies to ETFs and index funds as this is a tricky area.

Availability

ETFs are rarely available as investment options in defined contribution plans such aspensionfunds. Basically, index funds and actively managed mutual funds are the only choice. When shares of index funds and mutual funds are purchased as part of a retirement plan, there are usually no minimum purchase requirements.

If you're saving for retirement on an IKE, you have access to a wide range of ETFs and index funds. If you invest additional funds into a taxable investment account through an online brokerage, you will likely have access to all available funds and ETFs. In this case, minimum investment amounts and the availability of fractional shares may influence the choice of ETF or index fund.

Ultimately, choosing between an ETF and an index fund is probably less important than whether you choose to invest in your long-term goals with a passive investment vehicle. Whether you choose an Index ETF, Index Mutual Fund or a Managed Fund, you will benefit from lower fees, diversification and historically superior index-based trading performance.