ETFs vs index funds

Exchange-traded funds and index funds are both types of funds, as you can probably guess from their names. While they have plenty of similarities, they’re actually very different investment types with different investment strategies. Here are some of the key similarities and differences between ETFs and index funds.

• What are index funds?

  Index funds are a type of fund that aims to replicate the performance of an index, such as the S&P 500. They can do this with either physical replication or synthetic replication. With physical replication, the index fund holds the same stocks as the index in question. Synthetic replication aims to replicate the performance using other methods, sometimes with derivatives or swaps.

  Index funds are open-ended, which means that changes can be made at any time. As they don’t trade on stock exchanges, the shares are priced daily based on their current net asset value. This means that the net asset value always reflects the price of the underlying assets, unlike closed-ended funds that may trade at a discount or premium to net asset value.

  You can buy index funds with an investment platform.

• What are ETFs?

  ETFs are a type of fund that’s listed on a stock exchange. This means that their price is live, so you can make a purchase while the stock market is open for the listed price. As with funds, ETFs are collections of investments. The investments within an ETF might have a connecting factor, such as all being in the same sector or linked to a specific commodity. You can get index ETFs, which are exchange traded funds that track an index, like index funds. These are essentially index funds that are priced live and are traded on a stock exchange.

  ETFs are generally cheap and liquid (meaning they can be bought and sold easily). There’s loads of choice – you can get ETFs for a vast range of indices, commodities and other asset classes.

  ETFs generally have a broader range of investment options than index funds, incorporating currencies, commodities and interest rates. They can also incorporate leverage and it is possible to buy “short” ETFs, where investors can benefit from the falling price in an index. This makes them popular with traders taking short-term positions in markets or looking for nuanced portfolio positioning.

  Like index funds, you can typically buy ETFs with an investment platform.

ETFs vs index funds: At a glance

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What’s the difference between an index fund and an ETF?

These are simply two different types of fund that are traded slightly differently. Both of them will offer you good diversification and low costs. The main difference is that ETFs are traded on stock exchanges, so they may be more accessible than index funds. You are able to get index ETFs, if you’re interested in tracking a stock market index.

Both index funds and ETFs are liquid, meaning they’re easy to sell, and both are passive, meaning they need little intervention.

If you’re trying to choose between index funds and ETFs, you could always choose both — invest in an index fund that tracks an index that you’re a fan of and an ETF for a sector or country that wouldn’t be widely covered by your index fund. This would give you better diversification.

ETFs vs index funds: Fees

You’ll encounter fees with most investments — here are some of the fees you’ll come across with index funds and ETFs.

• Broker fees

Because ETFs trade like normal shares, investors need to pay a broker fee each time they make a transaction. Depending on the platform, this can mount up, which can make them a poor choice for regular savers trying to put small amounts to work every month – the dealing costs can end up being a disproportionate amount of the overall investment.

• Bid-offer spread

With ETFs, investors also need to factor in the bid-offer spread (the gap between the price at which the broker is prepared to buy and sell). This is usually very small for large, liquid ETFs based on major indices, but can widen out for smaller ETFs.

• Annual management fee

For both ETFs and index funds, investors will pay a small annual management fee plus any fee for holding the funds on an investment platform.

The difference in the annual management fee between ETFs and their index fund equivalent is relatively small.

• Rebalancing costs

Open-ended funds need to rebalance constantly to adjust for inflows and outflows. This creates some trading costs. This doesn’t happen with ETFs, which have a unique process called creation/redemption in-kind where shares of ETFs are created and redeemed with a like-for-like basket of securities. This means ETFs don’t have these transaction costs.

• Cash drag

Open-ended funds need to hold some cash to meet redemptions. This is cash that is not at work in the market and not earning dividends at any given moment. While this may benefit an index fund at times when the market is falling, for the most part, it will exert a small drag effect on returns.

• Dividend policy

Index funds reinvest dividends immediately (unless the unitholder is holding income units, in which case they are paid out). The nature of ETFs means that dividends need to be held in cash until the end of the quarter. This can make a difference if dividends are high and shares prices are rising quickly.

ETFs vs index funds: Which is for me?

Neither of these is necessarily better than the other. The right option will depend on you, your circumstances and your investment ambitions. However, it is possible to make some general points:

Which should I choose: Index funds or ETFs?

Bottom line

ETFs and index funds are two different types of fund, so both let you invest in a range of investments in one go. Index funds track a specific stock market index, while ETFs have the possibility for broader investment types, and therefore better diversification. In practice, the difference between the returns from an ETF and from an index fund from the same provider is likely to be minimal. Costs and performance are likely to be similar. The real decision is on the type of investor you are and on how the fund will be bought and sold.

Written by

Zoe Stabler DipFA

Senior writer

Zoe was a senior writer at Finder specialising in investment and banking, and during this time, she joined the Women in FinTech Powerlist 2022. She is currently a senior money writer at Be Clever With Your Cash. Zoe has a BA in English literature and a Diploma for Financial Advisers. She has several years of experience in writing about all things personal finance. Zoe has a particular love for spreadsheets, having also worked as a management accountant. In her spare time, you’ll find Zoe skating at her local ice rink. See full bio

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Zoe has written 165 Finder guides across topics including:

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