Investors trading for a long time earlier had limited markets to invest their funds. There were forex, stock, commodities, and precious metals that ruled the financial markets. But as technology and advancements hit the world, there were several new possibilities were added to it. Cryptocurrencies, index funds, contracts of difference, exchange-traded funds, etc.
The article will help readers and traders explore the two passive financial market investments. Index funds and ETFs are frequently traded instruments of the market due to their good market returns and popularity among investors. Index funds vs ETFs give an overview of the trading instruments and what similarities and differences they share for investors to know.
With this, readers will understand the two market instruments and how investors can trade them to earn good market returns. Index funds and ETFs are both significant for stock market investors, where an index fund is a mutual fund or ETF and an ETF is the collection of securities that could be bonds, shares, or other market instruments. So, let’s quickly understand the terminologies and what makes them different in the market.
An index fund is a market investment where traders can invest their funds in types of mutual funds or exchange-traded funds (ETFs). When traders invest their money in index funds, they have the motive of constructing their portfolio, which tracks the elements of the financial market index. The market index here means the holdings of the investment representing the financial segment.
Investors calculate the index value of the security from the prices of the underlying instruments. These have their values based on their market capital weight, revenue weight, fundamental weight, or float weight. Some of the index funds are Standard & Poor’s Index (S&P 500), FTSE 100, etc.
With the investment in index funds and primarily in mutual funds, traders get good market exposure, low portfolio turnover, and operating expenses. The index funds basically follow their benchmark index without taking into consideration the state of markets.
Generally, traders invest in index funds as they consider it an ideal portfolio holding for retirement like the individual retirement accounts, 401(k) accounts, etc. Even the legendary market investors believe index funds are suitable for investments as they help in saving for the future. Investors with index funds have a bundle of shares of the company or mutual funds at a low price than buying shares of a company at a high value.
How does an Index Fund operate?
Indexing in the market is passive fund management; the traders here have a fund portfolio manager that actively picks the stocks and has a market timing; that is selecting the assets or securities that could be invested in and have strategies to buy and sell them in the market. The fund manager helps in building a portfolio that mirrors the security or asset traded for a particular index.
So, the basic idea of trading is by mimicking the profile of the index – the stock market in a segment or a whole. Here the fund will track its performance for investing. The market has an index and an index fund for every financial market, and traders can invest in the one they find suitable. Below is the list of famous indexes of the financial market:
- S&P 500
- NASDAQ 100
- MSCI EAFE
The portfolio of the index funds changes only when their benchmark indexes make a change. Let’s say the fund follows the weighted index, so the manager here may rebalance for a period of time the percentage of various securities reflecting the weight of their presence in the benchmark.
Weighting is a famous method used for index funds; it balances out the influence of a single holding in an index.
Exchange-Traded Fund (ETF)
Exchange-traded funds (ETFs) are the collection of securities from various markets; they could be shares, bonds, money market instruments, etc. These track the underlying assets to understand the market position and invest funds. Hence, an ETF is a mashup of many investments having the most desirable attributes for the two frequently traded financial instruments; mutual funds and stocks.
It is said that ETF funds are similar to mutual funds as they have the same structure, regulations, and process of management. In addition, they are traded in pools similar to mutual funds with diversified investments. A trader can invest the funds with ETFs in stocks, commodities, bonds, currencies, options, or a mix of all these. Moreover, these can be traded the same way as stocks on a stock exchange.
Types of ETFs
Exchange-traded funds are of several types that are accessible in the market for investment. Below the types of ETFs are discussed, giving a glimpse of the various ETFs traders can make money from:
Bond ETFs are tailored ETFs that are typical in nature and offer exposure to the investors to different types of bonds in the market. Traders who wish to invest in bonds can take advantage of the mitigation of the bonds. These mitigate up and down and thus diversify the portfolio for investors.
Currency ETFs are securities that allow investors to participate in the forex market without buying the specific currency. The thought behind such an investment is to track and make money from the market fluctuations of the currency or the basket of currencies.
With the index, ETF investors are able to match the performance of the underlying index with the index fund. Investors can further divide these into replication and representative ETFs. When an index fund invests entirely in the assets underlying the index is termed the replication of the ETFs. Whereas representative ETFs are the investment where the majority of the fund’s corpus is invested in the representative samples.
While the remaining is invested in other securities of the market like options, futures, forwards, etc.
Other than these, there are Gold ETFs, Liquid ETFs, Inverse ETFs, etc., that investors can fund to earn money.
How Traders can take positions on ETFs?
ETFs are good investments to get market exposure for short-term price fluctuations in certain market sectors. In trading, ETFs traders can even use the CFDs to get access to the leverage facility. Hence, getting more exposure to the ETF selected. Traders can open their market position for a fraction of the cost and have high market profits. However, traders should be careful as the risk with leverage is also enhanced.
As the loss is calculated on the basis of the trade size position and not the cost of the initial opening. Therefore for trading ETFs with leverage, traders should have a risk management strategy to minimize their risks.
ETFs are a good source of investment funds in the market, although traders should analyze the market first before taking any step. They can invest through online brokers offering such services and make most of their trade with the services offered for market prediction.
Index Funds vs ETFs: Similarities
Before knowing what makes the two passive investments different, let’s understand the similarities shared by them. Index funds and ETFs both are traded highly in the market and make together several individual investments such as stocks or bonds. There are many reasons that make them frequently traded in the markets and a good choice for profit earning.
Mentioned below are the points that make them similar and wanted investment among traders:
Investing in a few index funds or ETFs is an excellent choice for diversifying the portfolio. They will be able to hold a large number of shares of the indexes such as the S&P 500 or any other. Thus having exposure to many companies from various countries. Thus, a highly important aspect of index funds and ETF trading.
Minimized Cost/ Low Cost
The investments in index funds and ETFs are passive, which means these are based on the index. The index is a subset of the broader investing market and is compared with an actively managed fund similar to mutual funds. Here a human broker works to actively choose the investment that results in high costs for the investor in the form of the expense ratio.
There are actively managed ETFs also that are available in the market. Traders can choose their investments wisely and benefit from the trade.
Long Term Returns
Actively managed and passive investments in funds tend to be outperforming; thus, long-term investors find these highly attractive. The passive investments in funds follow the ups and downs of the index, which is tracked. The index has a history of showing positive returns from the market.
Index Funds vs ETFs: Differences
Index funds and ETFs share some key differences, which are discussed below for a broader aspect and understanding of the readers. The two are passive investments with long-term market returns but still have various ways of trading, making them stand differently in the financial markets. Let’s understand the difference between these two:
Buying and Selling
The most essential and biggest difference between index funds and ETFs is their trading. The ETFs are traded the whole day in similar ways as stocks, but in contrast, the index funds are allowed to be traded at the end of the day at the set price. This is what generally differentiates these two passive investments.
The long-term market traders have no issue with the trading style of index funds as the end-day pricing won’t really impact the years of trading. But, for day traders, it is a concern as traders should better prefer ETFs. These are traded within a day like stocks, and investors can benefit from portfolio diversification.
Long-term investments are good for both the instruments of the market. However, the ETFs are available for the whole day and are less risky compared to other investments.
The minimum investment required for the two passively managed instruments is different. ETFs have less required investment than index funds. The ETFs mostly need the amount of a single share to purchase, and even brokers offering ETFs have the option of fractions, making it low for investment.
While the index funds have high investment requirements. It is higher than a single share price. So, traders must know these aspects of the instruments for informed trading and decisions.
The traders that have low minimum investment value can either go for ETFs or index funds that are offered by brokers with no minimum investment.
Capital Gain Tax
Capital gain tax is the expense that investors are required to pay for trading in the financial market. ETFs are more efficient in this respect of the trade when compared to index funds. This is due to the structure of the ETFs; in the trading of the ETF, the investor sells it to other investors who purchase it, thus having direct cash from them. The capital gains tax here is of the ETF holder alone.
In contrast, when trading index funds, the investor has to redeem them from the fund manager to get cash. Which further requires the manager to sell it to generate cash. So, here the net gains are passed on to every investor with shares in the fund. Hence, the investors can owe capital gain tax without even selling the share.
Cost of Ownership
If we talk about the aspect of ownership of index funds and ETFs, then it is said that these two are cheap as per the expense ratio. Another thing that comes under the cost is the trading commissions. In the trade of an ETF, if the broker has a commission charge, then they’ll have a flat fee every time ETFs are bought or sold. So, if one is a regular trader, then they would have high costs.
The index funds have transaction fees when traded; thus, an investor should check the charges and go with the one having a low cost.
Moreover, the ETFs have spread charges that are not available for index funds.
Trading in the financial markets needs a lot of perspective and factors to be studied by the investors. ETF and index funds both are great trading instruments of the financial markets. However, traders should analyze their market potential before trading. For this, they can take the help of brokers providing services.
One such online broker is ABInvesting, which has index funds and ETFs to trade and the best services that could be used for analyzing the market with tools, indicators, and trading platforms. Although, the broker should be chosen wisely by checking the services, instruments, and regulations.