Index funds vs ETFs: a crucial decision for passive investors

In the world of passive investing, a fundamental question often arises: should you opt for index funds or ETFs?

When it comes to passive investment, index funds and ETFs emerge as the primary contenders.

Both index funds and ETFs share a common philosophy and essence: they aim to replicate specific indices or sectors. However, despite this similarity, there are notable differences in their operation and taxation, factors that can significantly influence your investment strategy and portfolio objectives.

In this index funds vs ETFs article, we’ll explore both options so you can find out which one is the best for you.

Index funds: what are they and how do they work?

Index funds aim to replicate as accurately as possible the performance of a given index, both the bullish and bearish movements. This is the main difference between actively managed funds and index funds – active management seeks to outperform the market, while index funds simply aim to replicate a given market performance.

Due to replication objectives, index funds are often more affordable regarding costs compared to actively managed funds. Index funds follow a more passive and streamlined approach compared to actively managed funds, requiring less frequent and hands-on management, as they aim to replicate the holdings of a specific market index.

Here are some examples of index funds:

ETFs: what are they and how do they work?

Exchange-traded funds (ETFs) are a type of fund designed to replicate specific market indices. However, they differ from traditional index funds in that ETFs are actively traded on the stock market, functioning much like individual stocks.

ETFs can be easily bought and sold throughout the market hours, unlike index funds, which are typically traded only after the market closes.

The replication process in ETFs can be achieved through two methods:

1. Physical Replication: This approach involves replicating a stock index exactly. For instance, if an ETF aims to physically replicate the FTSE 100 index, its portfolio should consist of shares of companies that mirror the composition and weight of the index constituents.
2. Synthetic Replication: In this method, the ETF’s portfolio is not directly comprised of the actual shares of the index constituents. Instead, the fund invests in derivatives (such as swaps) and enters into agreements with counterparties to achieve the desired index performance.

Physical ETF vs synthetic ETF: what are the differences?

As briefly mentioned above, physical ETFs hold actual assets, while synthetic ETFs use derivatives instead. Intuitively, synthetic ETFs carry more risk than physical ETFs, but for diligent investors who understand these risks, synthetic ETFs can generate higher returns. In addition, synthetic ETFs are often used to gain exposure to exotic markets, which are much harder to access.

Here are some examples of ETFs:

To find out more about types of ETFs, have a look at accumulating vs distributing ETF and ETF vs ETC vs ETN.

Differences between index funds and ETFs

Let’s explore the key distinctions between index funds and ETFs. Understanding these characteristics will help you determine which one aligns better with your passive strategy.

Operations and flexibility

ETFs have a slight advantage in terms of liquidity, offering quicker transactions compared to index funds. This is because they are listed on exchanges and can be traded at any time during trading hours, unlike funds which are available for trading only at the end of the trading day after the markets close.

In other words, with an index fund, you can place buy or sell orders at any time, and the execution will take place at the end of the trading day. Consequently, the exact fund price is known only by the end of the day when the fund’s share value is calculated.

On the other hand, ETFs provide real-time information, allowing instant knowledge of prices, and offer immediate execution of sale orders. This speed can be crucial depending on your investment strategy or during times of significant market declines.

Number of index funds and ETFs

As mentioned above, ETFs are known for greater liquidity due to their stock-like structure. If variety is what you seek, ETFs provide a much larger and more diverse selection compared to index funds.

ETFs offer greater versatility, enabling investment in specific sectors and countries not covered by index funds, and a wider range of assets.

Commissions and costs

Both ETFs and index funds are cost-effective investment tools. However, they differ in terms of cost structure. Both index funds and ETFs are typically passively managed. The type of management can increase the costs significantly – for instance, nowadays, more and more actively managed ETFs have mushroomed.

Overall, it is important to verify the costs of each fund or exchange-traded fund before investing. Also, the brokerage account that you must use to invest in these assets may come with extra fees, such as commissions when placing orders. Have a look at the best ETF brokers for additional information.

Taxes

If you hold your assets in a general account, ETFs and index funds may be taxed differently, but in general, funds are treated similarly in the UK. One important aspect is the country of issue: if your fund was issued abroad, you will most likely have to pay higher taxes than for a UK-issued fund.

Over 75% of ETFs in the UK have a “reporting” or “distributor” status – this is ideal because the ETF is subject to capital gains tax (which is usually lower than income tax). Keep in mind that any dividends coming from the fund (if any), are still subject to income tax.

You may have to contact HMRC or government information to understand taxes due in your personal circumstances, as these may vary according to your other sources of income, personal allowances, income tax bracket, and others.

Learn more about investing in funds

• Best ETF brokers
• Best ETFs
• How to choose an ETF
• Index fund guide
• Investing in Dow Jones ETFs
• Best Vanguard ETFs
• Best Amundi ETFs
• Best FTSE100 ETFs

Conclusions: is an index fund or an ETF better?

The competition between index funds and ETFs for dominance in passive management is a reality. ETFs have gained ground over index funds, thanks in large part to their extensive variety in the market.

ETFs offer the opportunity to invest in highly specific areas such as marijuana or artificial intelligence, which is not possible with index funds. Moreover, ETFs allow for intraday trading, while index funds execute purchases and sales at the day’s closing value.

It’s crucial to consider the actual fund’s cost structure and the broker’s costs when investing in ETFs or index funds, which may impact costs differently. Funds with passive management usually have lower costs and actively managed funds.

In conclusion, if your aim is to invest in specific sectors, ETFs are the ideal choice due to their greater variety. However, if your focus is on replicating common stock indices, there is a wide range of index funds available.

It’s important to note that you don’t have to choose between one or the other exclusively. ETFs and index funds can be completely compatible. For instance, you can utilise index funds as the core of your portfolio and use ETFs to access specific sectors. A hybrid approach allows you to leverage the strengths of both options.

Ultimately, the choice depends on your investment objectives, risk tolerance, and preferences, making it essential to assess which option aligns best with your financial goals.

Index funds vs ETFs: FAQ