Some of you may have heard the terms “Index Fund” or “Exchange Traded Fund (ETF)” used and always wondered what they were or how they were different. I did…and it turns out I had them all wrong. So this week’s post will help you 1) avoid any confusion of the two, 2) understand the benefits of both and 3) even wow your friends at parties. So read on! PS – One of those statements is less true than the other two.
Okie Dokie….first let me briefly explain an Index Fund. It’s a mutual fund that was created to mimic a major Market Index (such as the Dow Jones, NASDAQ or S&P 500). You can also find Index Funds that track bond markets, international markets, etc. It was created because fund managers would claim that their mutual funds could beat the market, but the truth is many funds fall short of the market’s return. So one day John Bogle of Vanguard said “if you can’t beat the markets, join ‘em!” and the Index Fund was born. Index Funds are also an ideal mutual fund choice because once they’re created; they’re pretty low maintenance to manage which means lower fees for you.
Now on to an ETF. They are really similar to an Index Fund in that they also track a major Market Index. But an ETF isn’t a mutual fund, it’s a share of stock. So with an ETF you own a share of stock that represents many other shares of stock.
Both are ideal if you want to watch the news each night and hear Brian Williams tell you how the Dow or NASDAQ or did, knowing that your investment did the exact same thing. But they do have some differences you should know about:
Trading: Because an ETF is a stock, its price will fluctuate and can be traded throughout the day. Index Funds, like all mutual funds, are priced and can only be traded once a day after the markets close. So you have greater flexibility about when you can buy and sell your shares with the ETF.
Fees: You pay low or no management fees with ETFs. However, you do pay a commission per trade just like you would for any other stock purchase (some can be as low as $7 per trade). If you are someone who would like to reinvest continually on a regular basis (say once a month), you would be better off with an Index Fund where you’re not paying a commission with each purchase. But if you plan to make a large one time purchase, go with the ETF. (Side note: If you do go with an Index Fund, you should still make sure you are choosing one with the lowest management fees possible.)
Dividends: If you invest in an ETF, any dividends earned from that fund will be distributed directly to you and it is up to you to reinvest them (and pay an additional commission for that trade). Index Funds automatically reinvest dividends back into the fund for you.
Taxes: ETFs have two advantages over Index Funds when it comes to capital gains tax due to the way Uncle Sam treats each investment. With an Index Fund, assets within the fund are actively traded by a fund manager. Each time they are sold for a profit, there is a capital gains tax which the investor must pay. With an ETF, you only realize capital gains once when the entire ETF has been sold and not while you’re holding an ETF. So, with an ETF you’ll probably pay less tax over the life of the investment and you pay those taxes less often.
So, which one is right for you? It depends on how much you want to invest and how often. But both are a great investment option that can help diversify your portfolio while keeping costs low.
Photo Credit: Mike Linksvayer