Index Funds vs. ETFs

Personal Finance
a pen and glasses lying on top of a paper report of index funds and etfs

Index funds and ETFs are both low-cost and extremely tax efficient, but which is a better investment? Both funds are very similar, but making the wrong choice can cost you money and waste precious time. Comparing the differences between ETFs and index funds will show how you can get the most bang for your buck.

Costs

The costs for index funds and ETFs can easily vary based on management fees, shareholder transaction costs, and taxation. Usually, index funds are the cheapest type of investment to own because they aren’t actively managed. However, this is on a case by case basis.

Sometimes, the difference in fees might favor one type over the other. For example, an investor can purchase no-load index funds without incurring transaction costs. Investors buying ETFs must pay brokerage commissions. On the other hand, investors may also pay hefty management fees on certain funds. For example, the Vanguard 500 Index Fund charges 0.05% each year. The Rydex S&P 500 Fund – Class C charges an astounding 2.31%.

Tax Differences

Both index funds and ETFs are extremely tax efficient. Index funds are particularly tax-efficient because they’re passively traded. They rarely trigger capital gains taxes for their owners due to the infrequency of trading. However, ETFs are much more tax efficient because they don’t buy or sell stock for cash. Unlike index funds, a person simply sells shares of the ETF on the stock market. When investors redeem an index fund investment, the fund sells stocks for cash to pay the investor for the shares. This necessitates a tax payment.

Dividends

ETFs and index funds don’t handle dividends similarly. At the end of each quarter, ETFs will pass all accumulated dividends or interest received from the underlying securities to the shareholders. Index funds invest their dividends or interest income immediately to compound the investment and generate even more earnings.

Rebalancing

Rebalancing is the process of realigning the weightings of a portfolio. This involves buying and selling assets to maintain the desired levels of asset allocation. ETFs can make it nearly impossible for some investors to rebalance their portfolio due to the large number of securities mixed into one exchange-traded fund.

On the other hand, it’s possible to buy and sell index funds to achieve an exact level of asset allocation because the investor can purchase fractional units. This is especially easy because no-load funds lack transaction costs, which decreases the overall cost of rebalancing a portfolio.

Liquidity

Because index funds are mutual funds, you’ll get end-of-day pricing when you buy or sell the asset. In general, you can sell index funds within a short period of time without there being much difference between the selling price and the current market value.

The liquidity of an ETF varies quite a bit based on the composition, trading volume of the individual securities that make up the ETF, the trading volume of the ETF itself, and the investment environment. If a market sector becomes sought after, the ETF will be sought after, and lead to temporary liquidity issues. However, traders can continue to buy and sell ETFs during extended trading hours.

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