If you’re not sure how exchange traded funds (ETFs) differ from index funds, you’re probably in the majority (and you’re in the right place to find out more). ETFs and funds offer similar features, such as tracking the performance of assets on the stock market, but are bought and sold differently. On this page, we explain what ETFs and funds are and how they differ, so you have the information you need to determine which you might prefer to invest in.
- ETFs and funds are similar because they help you track stocks and their performance on the current stock market
- ETFs and funds are bought and sold differently. You can buy and sell ETFs any time the stock markets are open, while index fund transactions can only take place when share prices are set at the end of the trading day
- ETFs and funds can both be passively managed, which means you don’t have to invest in a fund manager, cutting out some of the cost
Table of Contents
What are ETFs and funds?
ETF stands for exchange traded funds and is a type of investment fund that allows you to purchase a number of individual stocks in one single transaction. This means that when you make a purchase, you’re buying a wide variety of assets. These assets might include things like stocks in various companies, or commodities such as gold and crude oil. You can manage ETFs passively or digitally using mathematical algorithms that allow you to track entire economic sectors or industries.
Funds, also known as index funds, track an established market index. Index funds are similar to ETFs in that as the goal isn’t necessarily to beat the market, you can also manage them passively.
Both ETFs and funds potentially allow you to benefit from a market’s long-term growth and save you the hassle of doing a lot of research to figure out which specific investments might be most beneficial for you.
What are the differences between ETFs and funds?
How they’re bought and sold
The main difference between ETFs and funds is the way they’re bought and sold. You can make ETF trades throughout the day, whereas with an index fund, you’re restricted to buying or selling until the prices are set at the end of each trading day.
You could consider ETFs and funds as long-term investment options, but because of the difference in how you make trades, ETFs might be less risky, as you can buy and sell at any time.
ETFs have lower minimum investments than funds because, in most ETF transactions, you’ll only pay the amount needed to purchase the shares. With index funds, brokers often require a minimum purchase amount, which may be higher than the actual share price.
Another difference is in the cost of owning ETFs and funds. Although they’re both typically inexpensive, the cost can differ based on trading commissions. If a broker requires a commission for a trade, you’ll typically pay a flat fee if you have an ETF, while index funds may come with transaction fees when you buy or sell.
Capital gains tax
When it comes to capital gains tax, an ETF might be more tax efficient. This is because when you sell an ETF, you’re selling it to another investor who’s willing to buy your share. The money is then paid directly to you, which means the capital gains you make on that sale are yours.
With index funds, you have to redeem the money from your sale from your fund manager, who’ll, in turn, have to sell securities to generate the money needed to pay you. The net gains pass to you as the investor with your shares of the fund, which means you may owe capital gains taxes on shares that you didn’t even sell.
Pros and cons of ETFs vs funds
Pros of ETFs
- Low fees: Since ETFs are passively managed, they tend to have lower management expenses, which in turn typically means their fees are low. ETFs might be a good option if you have a small budget.
- Beginner-friendly: ETFs often use ‘robo-advisors’, which can advise you on making ETF trades based on a digital mathematical algorithm that requires limited human intervention. These robo-advisors are usually low-cost and relatively low-risk. You’ll have the opportunity to invest in various markets that are calibrated to match your risk preferences.
Cons of ETFs
- Higher transaction costs: Depending on how you want to invest, ETFs often have higher transaction fees as they trade stocks throughout the day.
- Not usually suitable for short-term investing: ETFs essentially mirror market performance, which means you most likely won’t see any quick benefits or returns. It’s worth considering an ETF as a long-term investment.
Pros of funds
- Accessibility: Investing with an index fund means you can participate in a market of your choice. You’re essentially choosing a passive investment strategy, which might be more suitable for investors who are time-poor or don’t want to pay for a fund manager.
- Typically low cost: Compared to mutual funds, index funds have lower fees, mainly because you don’t need a manager to handle them. They also tend to have low (or no) trading commissions when you buy or sell.
Cons of funds
- Lack of flexibility: If you want to control where your money is going or experiment in different assets, investing in funds may not be right for you. Funds limit your control, and if you’re investing in a company that you’re not committed to, you won’t be able to change that.
- Lower rewards: index funds are usually lower risk than other funds, as you’re typically investing in established companies that have a steady growth. However, this also means you shouldn’t expect to see such high returns as you might with other types of funds that are designed to beat the market.
Is an ETF or a fund best for me?
There’s no definitive answer as to which option might be better for you, as it depends on your personal situations and financial goals. However, understanding the differences and what each investment has to offer can help you make a decision that suits you. It’s important to consider your investment preferences, how much risk you’re comfortable with when you invest, and what your investing goals are.
Should I consider a savings account instead?
If you think you might need access to your money in the shorter term and still want a good return that comes with less risk, a savings account, such as a notice account or a fixed rate bond, might be a better choice for you.
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