Deciding Between Investing in Index Funds or ETFs

An investor has several choices to make when they are deciding how to allocate their portfolio. One of these decisions involves using index funds, ETFs or both.

What Are the Differences Between Index Funds and ETFs?

Investing in an index fund allows investors to expose their capital to an index of stocks, such as the Dow Jones Industrial Average. These investment vehicles make it easier to diversify and take a small financial interest in hundreds of companies. Financial moguls, like Warren Buffett, take a similar approach by purchasing stocks in multiple companies. According to the experts at SoFi, “Buffett is an advocate of holding onto stocks for a long time and buying a slice of the company.” Taking this action by utilizing an index fund and holding for the long-term should be beneficial.

Some ETFs are also tied to the movements of benchmark indexes, like the S&P 500. Owning this investment vehicle allows an investor’s funds to mimic the underlying index’s performance. A few key differences include the following:

  • Higher minimum investments are usually associated with index funds
  • Index funds trade on the day’s closing price while ETFs are traded during market trading hours
  • ETFs may be less expensive when purchased using a commission-free platform
  • ETFs may have more tax advantages

Trading Advantages of Index Funds Versus ETFs

Trading an ETF is similar to buying and selling individual stocks. Limit or market orders can be used multiple times to buy or sell these investment vehicles during regular trading hours. Purchasing an index fund is completed based on the NAV, which is tallied at the end of the trading day, making them less liquid. However, index funds allow investors to purchase fixed dollar amounts, which is not permitted when trading an ETF.

Knowing the right amount of stocks to buy and hold can often be a dilemma for an investor. SoFi Invest answers your question of “how many stocks should you own?” by referencing one of the most well known investors. “Buffett’s investing advice is a study in simplicity. He thinks most investors should be prepared to hold stocks for a while and buy stuff they understand. Following this approach could mean sticking to a few core investments for a while and potentially not having to worry about spreading investments too thin or trying to time the market (buy low, sell high).” In other words, buying an index fund may provide an advantage when an investor wants to plan for the future. 

Which One Is Cheaper?

Purchasing an index fund can be more expensive than an ETF. Mutual fund companies usually have higher operating and administrative costs, which are passed along to investors. ETFs can also be cheaper to buy when using a commission-free platform, and they usually have significantly lower expenses. This aspect can differ significantly from a mutual fund that may include a sales load on the front or back-end. This extra charge is used to pay managers and other expenses. Investors may also be required to make a minimum investment to own an index fund.

Tax Advantages

One significant difference between index funds and ETF’s is associated with taxable events. If an investor sells their ETF, they’ll be taxed on any gains. A mutual fund manager may regularly decide to sell equities in a fund, increasing tax expenses and creating a disadvantage for an investor who owns this investment vehicle.

Making a decision on investment type to use may come down to the capital an investor has available. They may want to start with an ETF if they have limited funds and use an index fund later.

Ryan Kh