ETFs vs Index Funds: What’s the Difference?

ETFs vs Index Funds

At first glance it can be difficult to see the difference between ETFs (exchange traded funds) and index funds which on the surface both invest in particular indexes. There are no investment strategies, no manual input and no straying from the tracking principles of each investment vehicle. However, when you begin to dig a little deeper into the Canadian index tracker sector some significant differences between ETFs and index funds start to emerge.

Passive investment

The vast majority of investors using ETFs and index funds are looking for some form of passive investment which should in theory be less volatile than individual stocks. The idea is simple, invest into a fund which tracks a particular index and enjoy the long-term benefits of economic growth. However, as we saw during the 2008/9 mortgage crisis and the coronavirus pandemic, there are times when markets can be relatively volatile. 

  • ETFs

While it is possible to invest into an ETF and index fund holding securities mirroring a particular index, there tends to be more flexibility and choice with ETFs compared to index funds. For example you could look at an ETF investing in a particular commodity, business sector and country. There are also all-in-one ETF solutions which allow you to mix-and-match various in-house ETF funds under one umbrella, giving you a tailored spread of investments/risk profile.

  • Index funds

Canadian index funds tend to be more focused on the major indexes as opposed to giving the flexibility available with some ETF providers. These huge funds again simply mirror the chosen index with various adjustments as and when index weightings are amended. In many ways the simplicity of index funds is perfect for those looking at simple long-term index tracking passive investment.

Management fees

When looking towards more active research focused investment funds it is safe to say that you get what you pay for. Some of the better performing actively traded investment funds will charge management fees towards the higher end simply because of the services they provide and their track record. When it comes to ETF and index funds there is no real need for research, or decision making, because they simply track a chosen index, commodity or particular business sector. There is no picking and choosing between individual stocks, it is simply a case of setting up the underlying fund to reflect a particular index. However, the management fees charged by ETF and index funds do vary significantly.

  • ETF

You will find that the management fees charged by ETF are significantly less than their index fund counterparts. While the difference is not set in stone, for example an ETF and an index fund mirroring the same index/sector could conceivably charge fees of 0.1% per annum and 0.5% per annum respectively. Later in this article we will cover commission which adds an additional layer of expense when investing in an ETF compared to an index fund.

  • Index funds

As we touched on above, index funds tend to be significantly more expensive when it comes to annual management fees. This is a subject that is often brought up during investment meetings but it also needs to be taken into account together with commissions, covered further in this article.

Trading

One of the keys for many people looking to invest in ETF or index funds is the ability to trade their investments without restriction. This brings us onto a huge difference between ETF and index funds which can often come to the fore during volatile markets.

  • ETF

As the term suggests, exchange traded funds are openly tradable on stock exchanges during normal market hours. The fluctuations of the underlying ETF will reflect market/index movement during the day and overnight. The ability to trade ETF almost instantly, in many cases online, means that you have a greater degree of control on timing. If the markets are going into freefall then you can sell your ETFS intraday and, on the flipside of the coin, if markets are rising then you can buy at a relatively early stage of the changing trend.

  • Index funds

Index funds are not traded on open exchanges with transactions carried out directly with the company administering the fund. The price for individual index funds will be set at the end of the day thereby removing the opportunity to sell before a market goes into freefall. On the flipside of the coin, if markets are moving ahead you won’t be able to buy intraday or benefit from any additional upward movement. You would simply place an order which will be transacted when the price was fixed at the end of the day.

Rates of commission

In order for brokers to cover their costs they will charge a commission on all exchange traded investments. As a consequence, while the management expenses ratio (MER) for an ETF can be but a fraction of that of a comparable index fund, there is commission to take into account. Many would argue that passive investment should not incur significant trading commissions but this would depend on the individual investor.

  • ETFS

The majority of brokers will charge a set fee per ETF investment such as $9.99 if traded online. As a consequence, the larger the investment the smaller the commission as a percentage of funds invested.

  • Index funds

As we touched on above, Canadian index funds tend to charge a higher management fee compared to their ETF counterparts. However, as the majority of trade in index funds is done directly with the administrator there are no commissions. In many ways this balances up the differential in management fees although the impact would depend upon the amount invested and how regularly.

Long-term returns

While historically index tracker funds have performed better than their specialist investment fund counterparts on a long-term basis, not all tracker funds will perform in the same manner. Let’s assume you have $50,000 to invest in a passive investment on a long-term basis. How would this pan out with regards to ETFS and index funds?

  • ETFS

If we work on an ETF annual management charge of 0.1% this means that a $50,000 investment would incur a $50 charge, if the value of the fund remained static over the 12 month period. As a consequence, at the start of year two your investment will be worth $49,950. In simple terms, if the fund was to increase by 5% then you would benefit to the sum of 4.9% after the management charge. However, we would also need to take into account commission charged on the initial purchase.

  • Index funds

If we assume that an index fund has a management charge of 0.5% per annum this means that a $50,000 investment would incur a charge of $250 in the event that the fund remain static over the 12 month period. Therefore, your share of the investment fund would be $49,750 at the beginning of year two. Put this another way, if the fund was to increase by 5% per annum then you would only benefit to the tune of 4.5% per annum after the deduction of management fees.

Looking at one individual year in isolation you might think that the figures are fairly minuscule and nothing to be concerned about. However, what if you were to hold your ETF or index fund for 20 years, 30 years or even longer? The difference in management fees would start impacting long-term performance and the differentiation in terms of dollars would grow.

Regular investments

While many people will choose to make a one-off payment into an ETF or an index fund and maintain a passive investment approach for the longer term, some people prefer regular investments. For example, if you were to make an investment of $1000 a month into an ETF or index fund how would the figures stack up?

  • ETF

In theory, a flat $9.99 charge to buy an ETF online would immediately reduce your $1000 investment down to $990.01. So in effect you would be losing circa 1% a month in trading charges which would equate to around $120 per annum. As a consequence, while you would be paying a reduced management fee, your funds would already have been adjusted to take into account commission.

  • Index funds

As the majority of index funds can be traded directly with the fund administrator there is no commission and as a consequence you only need to take into account management fees. In the above example, this would save you circa $120 a year on a $12,000 investment. Therefore, it is not difficult to see why many people believe that index funds are more appropriate for this type of regular investment.

Summary

The Canadian ETF/index fund markets are huge and while the initial impression seems to be that ETFs are more flexible and more cost-effective this doesn’t necessarily give the overall picture. You need to take into account management fees, commission in the long-term and the impact on not only fund performance but funds available for investment. 

While many are attracted to ETFs because they tend to give a greater scope of investment opportunities, many passive investors may prefer the more basic less diversified opportunities presented by index funds. However, you have the ability to trade ETFs intraday while index funds have their price set at the end of each trading day. There is a lot to consider when looking at these two investment vehicles and much will depend on the amount invested, investment timescale and whether it is a one-off investment of part of a regular savings plan.

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