What Is the Difference Between an Index Fund and an ETF?, #113
Investing can be complicated and confusing. With so many investment strategies out there, it’s important to find the one that best works for your portfolio. On this episode, I’m going to discuss the difference between index funds and an ETF, their pros and cons, and how to determine which one is right for you.
You will want to hear this episode if you are interested in...
Defining index funds and ETFs [1:36]
Differentiating between index funds and ETFs [5:19]
Deciding which investment is right for you [12:01]
Understanding index funds and ETFs
An index fund is an investment designed to track a particular index. One of the most popular indexes is the S&P 500, an annual ranking of the top 500 companies doing business in the United States. Investors don’t own a piece of each of these companies in equal percentages, but rather the bigger companies in the index represent a larger percentage of your holdings. This is known as a cap-weighted index. Studies have shown that if you hold an index fund from year to year versus other investments where you have to pick individual companies to invest in, the index funds typically out-perform traditional investments. It’s better to own a broad portion of the market than try to guess which companies will give you the highest returns. Aside from the S&P 500, other indexes include the Dow Jones Industrial index, the Russell 2000 index, the IFA index, and hundreds more.
An exchange-traded fund, is otherwise known as an ETF. The first ETF was an S&P 500 index ETF created in 1993. After the stock market crashed in 1987, there were several investigations into how it happened and ways to prevent it in the future. A lack of liquidity in the futures market was cited as the reason for the single-day 25 percent dip. As a result, the ETF was born, allowing people to make multiple trades in the market without hurting the overall stock price. It took a while for ETFs to catch on. There were only 102 of these funds ten years after their inception. Today, however, there are over 7,000 ETFs on the market.
Weighing the pros and cons
Now that we understand what index funds and ETFs are, let’s look at a few of the major differences between the two. When we say the term index fund, the word fund means that it is a mutual fund. With any mutual fund, you have to place your buy or sell order before the stock market closes on one of its 255 open days per year. The price you receive, whether selling or buying, is determined by whatever the price is at 4pm when the market closes. If liquidity is important to you, index funds provide very little because you can only make one trade per day.
That’s why the ETF was created! Exchange-traded funds can be traded just like a stock during the market’s open hours, with the main difference being that ETFs have no limit to how many trades can be performed daily. Because ETFs are structured differently, they allow for this level of liquidity versus mutual funds that are limited to their closing price. Another major difference between ETFs and index funds is that mutual funds force you to regularly pay out capital gains taxes at the end of the year. Because mutual funds are pooled accounts, when stocks have to be sold off within the fund, you could be subject to taxes even if you didn’t make any money on your investment. Listen to this episode for more on the difference between index funds and ETFs!
Resources Mentioned
The Only Guide to a Winning Investment Strategy You'll Ever Need: The Way Smart Money Invests Today (Book)