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ETFs VS Index Funds

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ETF vs Index Funds | Top 8 Differences You Must Know!

Suresh, a 30-year-old investor, has been investing in mutual funds for the past few years. He came across the terms ‘Index Fund’ and ‘Exchange Traded Fund,’ which sounded like Mutual Funds, but he didn’t comprehend them. Suresh was perplexed by questions about the distinctions and similarities between Index Funds and ETFs and why they sound like mutual funds.

Many have the same doubt, and to answer that – Index funds and exchange-traded funds (ETFs) may appear to be the same thing, but they are not. They’re two of the most often used passive investment strategies.

But, before you move on to the differences, first understand what ETFs and index funds are.

What are ETFs?

Exchange-traded funds comprise of shares that make up popular indices like the NSE Nifty 50 and the BSE Sensex. If an ETF tracks a specific index, that index will include the same companies as the index, and their weighting will be the same. For liquidity, the ETF may also invest in money market securities. Returns on exchange-traded funds (ETFs) are generally predictable and will be close to the underlying index.

Even though multiple ETFs track the same index, their returns will differ due to differences in debt holdings, which affect their returns. ETF units are exchanged on stock markets the same way as shares are.

What are index funds?

A broad market exposure, low operating expenses, and low portfolio turnover are all claimed benefits of an index mutual fund. It is clear that managed capitals provide superior diversification than many direct stock investments. There are hundreds of such funds available, divided into two categories: active and passive funds. Actively managed funds use clever share selection to outperform the benchmark index. 

On the other hand, passive funds are just interested in seeing if they can meet the benchmark. As you may expect, passive funds are simply another name for index funds, which is how it earned its name. All stocks in any given index will be included in index funds in the exact ratios specified in the index.

Differences between ETFs and Index Funds

Minimum Investment

ETFs frequently have lower investment minimums than index funds. The majority of ETFs just demand the minimum amount to acquire a single share, and some brokers even provide fractional shares.

When it comes to index funds, brokers frequently impose minimums significantly greater than the average share price. Consider an ETF with a share price you can afford or an index fund with no minimum investment if you only have a small amount to invest.

Cost of owning them

ETFs and index funds may be pretty inexpensive to hold from an expense ratio standpoint – you can quickly find funds that cost less than 0.05 percent of your investment every year.

Another factor to consider is trading commissions. If your broker charges a commission then you will be paid a fixed fee every time you buy or sell an ETF, which might eat into your earnings if you’re a regular trader. Yet, some index funds have transaction fees when bought or sold, so compare costs before making a decision.

When purchasing ETFs, you’ll also pay a fee known as the bid-ask spread, something you won’t notice when you buy index funds. However, this cost is usually less when purchasing high-volume, broad market ETFs.

Making Transactions

From an expense ratio standpoint, ETFs and index funds may be quite inexpensive to hold – you can quickly find funds that cost less than 0.05 percent of your investment every year.

When it comes to ETFs, you can only purchase and sell them on a per-share basis. Although, because they trade continuously during the day, you can get a pretty decent idea of the price.

Since you don’t have to wait until the market closes for your deal to go through, ETFs are more liquid or easier to get around than index funds.

Final Thoughts

When investing in ETFs, retail investors rarely consider brokerage expenses. When buy-sell brokerage and the spread are taken into account, investors may wind up paying significantly more for ETFs than they would for an index.

Low-cost passive investments like index funds and ETFs are excellent long-term investments, but be sure the instrument you choose offers low-cost, efficient transactions.

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