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Have you heard the story about Warren Buffet betting a million dollars in 2007 that an index fund will outperform a group of hedge funds over a ten-year period?
He officially won that bet in 2017, and gave the money to charity.
More importantly for rookie investors, it highlights the fact that index funds can be used to establish a low-cost, low-risk, long-term investment portfolio.
The most common type of index funds in Australia are exchange traded funds (ETFs), but not all ETFs are index funds.
So, what’s the difference between an
index fund and ETF?
Jump straight to…
What is an Index Fund?
- An index fund is a managed fund (or mutual fund in America), which means an index fund is operated by fund managers who buy and sell shares on your behalf.
What differentiates an index fund from other managed funds?
Managed funds are usually actively managed funds, meaning your fund managers are involved in buying and selling shares or bonds on a daily basis.
Index funds are more known as passively managed funds.
An index is a yardstick used to measure investment performance and risk.
In an index fund, your fund manager will merely choose shares based on a stock market index, such as the ASX 200, instead of choosing individual stocks for you.
So, if a stock is removed from the ASX200 and replaced by another, the manager of the index fund will follow that action in their index fund shares.
Which begs the question:
Why pay management fees to your index fund manager?
Actually, it’s what makes index funds attractive.
Index funds typically offer lower fees since fund managers do not have to perform much heavy lifting. As a result, investing in index funds is less expensive for you.
Almost any type of fund can be an index fund; it all depends on the fund manager’s strategy. Depending on the kind of fund you choose, your super fund could even be an index fund.
Pros & Cons of an Index Fund
One of the primary attractions of index funds is that they provide quick diversification because you purchase a basket of stocks in a single transaction.
As a result, you will take on less risk than if you owned one share while profiting when the market as a whole rises.
Advantages of Index Funds
- Index funds are less expensive: Because passive funds just follow the index and don’t require fund managers to analyse companies to try and find hidden value, their fees and trading costs are lower than those of actively managed funds. High fees in managed funds can quickly eat away at any gains made.
- Index funds allow you to invest abroad: Certain index funds allow you to diversify by allowing you to invest in both domestic and overseas markets.
- Index funds can obtain greater profits: Over many years, many index funds have outperformed the average returns achieved by fund managers. They make strong investment sense when combined with cheaper fees.
- Index funds are easy to trade: Many of the ASX-listed ETFs are index funds, which are easily accessible through brokerage and investment platforms.
- Index funds have the potential to diversify your portfolio: Investing in an index fund provides access to a diverse range of listed companies from numerous industries.
- Index funds can be less risky: Because indices can be less volatile than individual stocks, index funds are thought to be a safer alternative to direct stock market investing.
Disadvantages of Index Funds
Naturally, no investment is ever completely “safe,” and investment funds come with associated risks.
- You risk losing your money: As with any investment, you take the good with the bad. When the index performs well, so too does your investment, but when the index falls, so does your investment.
- It is not a short-term strategy: Index funds have been known to deliver strong returns over long periods of time, which is why many investors consider them to be a good long-term investment option. That said, they are not renowned as a good short-term investment option. For this reason, if you invest in an index fund but need the money 6 months later, it’s possible you’ll have less than you started with.
- Not every asset is secure: Although many index funds mimic relatively safe big indices, a fund can be made up of any pool of assets. Some index funds track volatile global markets like oil, while others invest in even riskier assets. Do your homework at all times.
- Selling During a Recession: Antsy investors may be inclined to sell their fund if its value falls during an economic downturn. Investors need to remember that they are investing for the long term.
- Not all ETFs are index funds: ETFs come in a variety of shapes and sizes, and it’s worth noting that not all are managed passively.
What is an ETF?
An exchange traded fund (ETF) is a managed fund that can be bought or sold on a stock exchange throughout the day, such as the Australian Securities Exchange (ASX).
Most ETFs in Australia are considered passive investments that do not attempt to outperform the market.
The fund manager’s job is to keep track of the value of:
- an index, such as the ASX200
- a particular commodity, such as gold
The value of the ETF fluctuates in response to the index or asset it is tracking.
ETFs can either have a physical backing or a synthetic one.
- Physically-backed ETFs invest in the entire index or a subset of the index’s securities.
- Synthetic ETFs hold some underlying assets and employ swaps to replicate the movements of an index or asset. If an ETF is synthetic, the word “synthetic” must appear in its name. Synthetic ETFs face the added risk that the counterparty in the swap agreement will fail.
You do not own the underlying investments when you invest in an ETF. You own ETF units, whereas the ETF provider owns the shares or assets.
ETFs allow you to invest in a variety of asset classes and individual assets that are passively traded, such as:
- Australian shares
- International shares
- Industry sector shares (Australian or international share market, e.g. mining or financials)
- Fixed Income Investments (e.g. bonds)
- Precious Metals and Commodities
- Foreign Currencies
- Crypto Assets
Other ETFs also track an index or asset but they are not passively managed investment funds and can be risky. Among these actively traded ETFs are:
- Commodities traded on an exchange
- Notes traded on an exchange
- Certificates trade on an exchange
- Securities traded on an exchange
- Managed Funds traded on an exchange
- Hedge Funds traded on an exchange
Pros & Cons of ETFs
If you’re considering investing in an exchange traded fund (ETF), you should be aware of both the benefits and risks. It’s your hard-earned money on the line, so knowing what you’re buying could be beneficial.
| Advantages of ETFs | Disadvantages of ETFs |
| Diversification | Can’t replicate the index |
| Cost-effectiveness | Volatility |
| Convenience | Currency Risk |
| Transparency | Liquidity Risk |
| Selling in a downturn |
Advantages of ETFs
- Diversification: ETFs allow you to buy a collection of stocks or assets in a single transaction. This can aid in asset diversification. ETFs enable you to invest in markets or assets that might otherwise be difficult or expensive to access. You can also diversify across ETFs to reduce your risk of loss if an ETF provider fails.
- Cost-effectiveness: One of the most significant advantages of an ETF is its low cost. The fund may invest in as many as fifty different publicly traded stocks, yet there is only one brokerage fee. In addition, an ETF may have cheaper management expenses when compared to an actively managed fund.
- Convenience: Exchange-traded funds offer the same advantages as securities. As an investor, you have access to all of the tools accessible to stock investors, such as the ability to short or utilise limit and stop orders, as well as the ability to buy and sell whenever you want while the exchange is open.
- Transparency: With ETFs available on an online exchange, investors can always view the value of their investment and the purchase process is rather straightforward.
Disadvantages of ETFs
- ETFs will never exactly replicate the index: The most recent SPIVA report indicates that 95% of actively managed funds underperform against the index. Because of the management fees associated with ETFs, your return on investment will never match the actual index it tracks. The buy and sell prices of your fund shares can also differ from the underlying index’s net asset value, impacting your return.
- Volatility: While ETFs can help you diversify, the market or sector that the ETF is tracking may lose value. For example, if the ASX200 falls or a specific sector falls, so will the value of your ETF investment.
- Currency Risk: If the ETF invests in international assets, you run the risk of your results being impacted by currency fluctuations.
- Liquidity Risk: Certain ETFs invest in non-liquid assets, such as emerging market debt. This can make it difficult for the ETF provider to create or redeem securities at times.
- Selling in a Downturn: Anxious investors maye be tempted to sell their fund when its price drops during an economic recession. Investors should keep in mind they’re investing for the long term.
What Is the Difference Between an ETF and Index Fund?
If you got lost along the way and are still wondering what exactly makes an ETF different from an index fund, you can think of it this way…
The primary distinction between index funds and exchange-traded funds (ETFs):
- Index funds can only be traded at the end of the trading day, whereas
- ETFs can be traded throughout the day.
This means that an ETF can be traded like a stock, whereas an index fund can only be bought and sold at the conclusion of the trading day.
Other notable distinctions include:
- ETFs are publicly traded on a stock exchange: ETFs are traded on the stock exchange like shares, whereas index funds are unlisted managed funds.
- They are each priced differently: The price you pay for an ETF is its market value, which is determined by its stock market performance. The net asset value of the underlying securities is the price at which you can buy or sell an index fund.
- Purchasing and selling: ETFs participate in intraday trading, which means that fund managers can buy ETFs and sell them at any time during the trading day, whereas managed funds are valued only at the end of the day.
- There are no transaction fees with index funds: When buying or selling an ETF, there is nearly always a brokerage fee involved, but index funds typically avoid this cost. This means that a managed index fund can be a viable alternative for investors who want to add small amounts to their fund on a regular basis.
- ETFs are more tax efficient: Capital gains taxes on the transaction of selling your ETF is solely your responsibility. Whereas when withdrawing cash from an index fund, you must redeem it from the fund manager, who must then sell securities to produce the cash to pay you. When this sale results in a profit, the net gains are distributed to all investors who own shares in the fund, which means you could owe capital gains taxes without ever selling a single share.
- Minimum investment amount: An ETF can have a lower initial investment amount depending on the minimum number of shares to be purchased and its share price. An Index Fund can have a lower initial investment amount if it doesn’t impose a minimum investment amount.
| Exchange Traded Funds (ETFs) | Index Funds (IFs) |
| ETFs can be traded throughout the day | IFs can only be traded at the end of the day |
| ETFs are publicly traded on an exchange | IFs are not publicly traded on an exchange |
| ETF market value is determined by its stock market performance | IFs are traded according to the net asset value of its underlying securities |
| ETFs can be purchased or sold at any time during the trading day | IFs are valued only at the end of the day |
| ETFs have brokerage fees | IFs typically avoid brokerage fees |
| Your capital gains tax are your sole responsibility | Capital gains tax is shared among fund investors |
| Choose an ETF with a low share price | Get an index fund with no minimum investment amount |
Despite their differences, index funds and ETFs share many characteristics, including offering a well diversified portfolio, minimal investment expenses, and good long-term returns.
Are ETFs or Index Funds Cheaper Buy?
As mentioned earlier, minimum investment amounts for ETFs are generally lower when compared to Index Funds.
However, there are more aspects to consider beyond the minimum investment amount if you’re choosing between investment funds and ETFs.
Check the product disclosure statement (PDS) and get the necessary information to help you compare and decide.
A PDS should contain the following:
- what assets the funds invests in
- the risks of investing in the fund
- the benchmark or target return
- the fees
Compare funds that invest in the same type of assets that way you can easily compare their risks and benchmarks.
As for fees, ETFs, index funds and managed funds charge shareholders an expense ratio to cover total annual operating expenses.
The expense ratio is calculated as a percentage of the average net assets of a fund and can include a wide range of operational expenditures, including shareholder services, management, administrative, compliance, distribution, record-keeping fees, and other costs.
The expense ratio affects the fund’s returns to shareholders and, as a result, the value of your investment.
Ideally, you would want a fund with a lower expense ratio since a higher expense ratio may mean a lower return for you.
The information you gather will help you to determine which fund has a chance of giving you better returns.
Do ETFs or Index Funds Have Better Returns?
If we’re strictly comparing passive ETFs and index funds, long term returns from ETFs and index funds are comparable.
However, due to the nature of the two products, investors should be aware of the differences in trading, dividends, and cost.
In the end, the choice between a traditional index fund and an ETF comes down to which features you value the most.
If you need help identifying what you value in an investment or what investment product to choose before you start investing, but don’t know where to look for sound financial advice,
have a chat with our My Money Sorted.
The investment manager uses these to try to outperform an index and may employ high-risk trading strategies.
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