One of the most significant differences between an index fund and an ETFs is how they trade. Shares of ETFs trade like stocks; they’re bought and sold whenever markets are open. While you can order index fund shares whenever you wish, share purchases only happen once a day, after the markets close. This means that the price of any given ETF fluctuates throughout the trading day, while the price of an index fund only changes once a day.
Trading Fees
While both index funds and ETFs charge low expense ratios, additional fees beyond the expense ratio may look very different.
Most brokers have eliminated trading commissions on nearly all stock trades, and many charge no commission for ETF trades, either. Meanwhile, a broker’s sales commissions for index funds can be very expensive. That said, online brokers generally offer a selection of commission-free funds. There’s just no guarantee that the funds you want to buy are free of commissions.
Then there are load fees, another form of sales commission. Front-end load fees may be charged for buying funds while back-end load fees may be charged for selling funds. Load fees can be a percentage of your total purchase or a flat fee. ETFs lack load fees entirely.
So a given ETF may charge a higher annual expense ratio than an index fund you have your eye on, but you need to take into account the potential commissions and sales load fees charged by a comparable index fund.
Minimum Investment Amounts
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 set up regular contributions to a tax-advantaged retirement account, they can still be substantial.
Fractional Shares
Until recently, most ETFs were not available as fractional shares (depending on your brokerage, they still might not be). Index funds, on the other hand, have always been available in fractional amounts.
When you buy into an index fund, managers convert the dollar value of your investment into the correct number of shares based on the NAV the day of your purchase, regardless of whether you end up with a fractional share or not.
Fractional shares have the potential to help you get your money in the market sooner by letting you buy parts of full shares of funds instead of purchasing full, pricier shares. This also lets you better take advantage of dollar-cost averaging, which may help you pay less per share overall over time.
Tax Implications
ETFs are usually more tax efficient than managed funds, and, generally speaking, attract lower capital gains tax (CGT) compared to actively managed funds, which are traded more frequently. While you will pay capital gains taxes on any gains you realise when you sell shares of an index fund or an ETF, you do not pay taxes when the holdings in the ETF portfolio are adjusted by managers. In fact, tax efficiency is one of the big draw cards of ETFs.
Index funds, meanwhile, must buy and sell assets to adjust their portfolio to track the underlying index. The cost of any capital gains taxes from these sales are taken out of the fund portfolio NAV, which impacts the value of your index fund shares. That said, index fund holdings rarely change, so this may not be a huge issue for you.
In either case, speak with your accountant or financial advisor for more details on how tax, including capital gains tax, applies to ETFs and index funds as this is a complicated area.
Availability
ETFs are very seldom available as investment options in defined contribution plans, like superannuation funds. Generally, index funds and actively managed mutual funds are your only choice. When index fund and mutual fund shares are purchased in a retirement plan, there generally aren’t minimum purchase requirements.
If you save for retirement in an IRA, you’ll have access to a very wide range of ETFs and index funds. If you invest extra funds in a taxable investment account via an online brokerage, you’ll probably have access to all available funds and ETFs. In this case, minimum investment amounts and the availability of fractional shares may impact your choice of ETF vs index fund.
