Index Funds vs ETFs Explained

In this article we are going to cover what index funds and ETFs are, where they are similar, where they differ and which is a better investment.

Let’s be clear right from the off. Investing in either index funds or exchange traded funds (ETFs) can provide strong investment returns. And in fact they can both have a lot of shared benefits if you pick the right ones.

The main benefits shared by both types of fund are:

• Diversification
• Low costs
• Tax efficiency

In actual fact, that list could be extended. We’ll go into more details further on. But that doesn’t mean they are the same.

Index funds and ETFs have a number of key differences. Some of these are subtle. Some not so much!

A little help from Vanguard

To help emphasise the differences, it’s worth taking a trip over to Vanguard. Not just because they are basically a not for profit organisation. And not because they were the ones that actually pioneered index investing in the 1970s. And not even because they are one of the largest fund managers in the business.

No, we’ll use Vanguard because they offer a good range of both types of funds so its not in their interests to present one as any better than the other. We can look at index fund vs ETF options without bias.

On their UK website, Vanguard show detailed information about each fund they offer. More importantly, they also offer a summary of key information. Not only that, an option to invest now button sits at the bottom of every single one, implying that might just be enough info for you to make up your mind.

For our purposes we’ll take a look at two UK funds. One index fund and one ETF. In fact, we are going to compare two funds that track the FTSE100 index. We can do that because you can invest in ETFs that track indices. We’ll call them ETF tracking indexes for now.

In case you don’t know, the FTSE 100, often referred to as the Footsie is an index that tracks the 100 largest public companies by market capitalisation that trade on the London Stock Exchange (LSE). The name Footsie is an acronym of the index’s original parent companies, the Financial Times and the London Stock Exchange. It represents more than 80% of the LSE’s market capitalisation.

The image below shows Vanguard’s summary information for a FTSE 100 Index Fund (Index Unit Trust) and a FTSE100 ETF (UCITS ETF). Can you spot the difference between them?

Spot the difference

Eagle eyed readers will have spotted one difference: The ongoing charge (OCF). The index fund is 0.06% compared to 0.09% for the ETF.

Essentially, the only difference between the index fund and the ETF is cost. All other key characteristics shown in these Vanguard summaries are the same.

And that’s because both the Vanguard FTSE 100 Index Unit Trust and the Vanguard FTSE 100 UCITS ETF are essentially the same thing. Both follow the FTSE100 index. Both have the same companies in the fund in the same amounts. Both have the same Risk Level and on and on.

You’d find the same thing if you looked at the Vanguard S&P 500 index fund vs ETF equivalents or any other combination where both funds track an index.

And that’s because in reality they are both index funds!

You’d be forgiven for feeling confused right now, but don’t be. Index funds and ETFs have differences. Let’s take a look at exactly what these two types of fund are.

What’s an index fund?

An index fund is a basket of stocks or bonds that tracks an index.

Stock indexes are essentially collections of stocks meant to represent the stock market or a portion of it.

Perhaps, the most famous one of all is the S&P500 (Standard and Poor’s 500). This is an index that tracks 500 publicly traded US companies. It is considered by many to be the best indicator of US stock market performance. Similarly, the FTSE100 is the UK equivalent.

What is an ETF?

An ETF (Exchange traded fund) is a basket of stocks that trades on an exchange. And note, though it can, this basket doesn’t have to follow an index.

Here are the key differences between index funds and ETFs:

How and where you buy your fund

You typically buy index funds directly from the index fund company itself, whereas ETFs are freely exchanged on the stock market. This means anybody with a brokerage account can buy ETFs, whereas only investors eligible to buy directly from the fund provider can buy index funds.

In practice this often restricts certain groups from buying index funds, such as expats.

(That said there are some brokers that do allow expats to buy index funds. However, as yet, I’ve not come across one that doesn’t either charge a high fee or require a very high minimum investment for the privilege. If you are an expat don’t worry, though, there are plenty of investment platforms that allow you to buy ETFs)

What’s under the hood

Index funds contain baskets of stocks that follow an index. On the other hand an ETF can hold pretty much anything. There are plenty of ETFs that also follow an index, but at the same time, there are plenty of ETFs that hold other investment assets such as gold or Bitcoin.

Minimum investments required

The minimum investment for an index fund is often higher than for an ETF. That’s because you can only purchase index funds from particular platforms. If you purchase from a platform that has both like Vanguard UK minimums maybe the same. Vanguard’s lowest investment amount is £500 no matter which you choose. However, more likely a minimum investment for an index fund will be in the thousands of pounds.

On the other hand all investment platforms/stock brokers give you access to ETFs. And because ETFs can be bought and sold just like stocks you can invest in as little as one share. And there are plenty of ETFs out there that sell shares for less than a fiver!

When you can buy and sell the funds

The price of an index fund is calculated at the end of the trading day and as such you can only buy an index fund at that time. In practice this means no matter when you place your order to buy throughout the day, the order will only go through at the end of the day.

The downside of this is that the price may be higher at the end of the day than it was earlier on. Lots of things can happen during the course of a day that impact share prices.

On the other hand, ETFs can be bought and sold throughout the day based on real-time pricing. And as a result, day traders don’t invest in index funds. But, this shouldn’t be an issue for long term investors.

Sophisticated orders

Index funds are limited to buying and selling at one point during the day. On the other hand you can treat ETFs in just the same way as individual shares, meaning you can complete all kinds of sophisticated order types if you so desire.

Again, this is good for traders, but for long term investors, not so much.

Automation

It’s usually pretty straight forward to set up automatic orders with index funds.

This means you can automatically send money directly to your investment account once a month when you receive your salary without even thinking about it. The fund provider will handle allocating the money to your funds.

You don’t usually have that option with ETFs meaning you have to do everything yourself.

Though in theory that’s not much of an issue because you can buy and sell ETFs in a couple of mouse clicks, the very fact you have to do something at all can prove problematic at times.

For example, it’s very difficult for most people to click ‘buy’ when stock markets are plummeting, or click sell when they are rocketing upwards.

Active vs passive fund management

All index funds are passively managed. They attempt to closely track a benchmark index like the S&P 500 or FTSE100.

In practice, this takes decision making out of the process. The S&P500 contains Apple for example. If the price of shares in Apple goes up by 10%, then the fund manager (or algorithm) simply buys 10% more Apple stock. Easy. No decision to make here.

On the other hand active management requires a fund manager (or some kind of fancy algorithm) that makes decisions in order to try and get higher returns. Active managers that consistently beat the market can become famous. A certain Warren Buffett springs to mind.

The active vs passive debate is a big one. We’ve written dedicated articles about it. And others have gone so far as to write books focused entirely on that one subject.

My take on it goes a little like this. It maybe possible for some outstanding individuals to beat the market. However, more and more evidence is mounting that these people are extremely rare. Because of this, finding one is just about as difficult as choosing an individual company to invest in.

People think they can just look at a fund managers track record to decide. If the fund has been outperforming then hey presto!

If only it were so simple! The key thing is the past is not an indicator of future performance. In fact, the more successful a fund manager has been the more likely they are going to underperform in the future.

Feel free to do your own research into this if you aren’t convinced. I’d recommend starting with SPIVA.

Check out the chart below showing US stockmarket (S&P composite 1500) vs active managers. In other words a US stock market index vs active management:

Total US stock market index vs active managers

The charts above don’t look very good for active managers. If we give them the benefit of the doubt by assuming you don’t care about risk and just look at the absolute returns (light blue), over 3 years 72% of them underperformed the index. Over 5 years 75% of them underperformed the index. Over 10 years 86% of them underperformed their index and over 20 years 90% of them underperformed the index.

In other words, if you went with the index you outperform 90% of active managers over a 20 year period!

In the western world you expect to live into your mid 80s, so even if you are in your 60s you should be investing for at least 20 years. In your 50s 30 years. In your 40s 40 years. You get the picture.

I think it’s pretty obvious that as your time horizon increases so does your chance of outperforming active managers by following an index.

But perhaps what’s not quite as obvious is the fact the fund manager that outperforms during one period tends to underperform during the next period! That means picking a fund manager based on a good track record could be just about the worst thing you can do.

I’ve got friends that see this data and just think there must be some catch and still try to choose fund managers with good track records. And to be honest, I totally understand. The idea the active fund managers underperform indexes is pretty counter intuitive when you first come across it.

However, when you look into it, things become a little clearer. See ‘why do index funds out perform’ below for my take on what is really going on.

Fund costs

Index funds and ETFs can both be extremely low lost ways to invest. If they both follow an index that is. But if they are different, it will usually be the index fund that is cheaper. In turn this will have a slight impact on index fund vs ETF performance. In the Vanguard FTSE 100 example we looked at in the beginning of this article there was a cost difference of 0.03%.

As an example lets say you got 7% returns on £100K over 25 years of saving for retirement with with your index fund after fees. You’d end up with just about £543,000. With the ETF version you’d end up with £539,000. That’s a difference of approximately £4,000.

Not a lot when we are talking over half a million pounds, but a difference all the same. So I think what this means is, if you have a choice between the two you’d usually want to go for the index fund. However, if the index fund isn’t available or you have another reason to go with an ETF, just go with it and don’t sweat the difference. This certainly won’t make or break your investment success.

Tax efficiency

Nobody likes talking about tax. But in this case we can’t avoid it because both of these are highly tax efficient.

The reason for this is that funds following indices don’t change their holdings very often. This is powerful because it does wonders for reducing capital gains tax.

That said, the underlying workings of ETFs make them even more tax efficient when following indices. ETFs involve Authorised Participants (APs) which allow tax free in kind transactions and because they are traded on exchanges between investors they don’t generate capital gains events.

But again, just to reiterate this only works perfectly for an ETF that follows an index. If an ETF was managed by a highly active manager that was constantly buying and selling shares tax costs could be high.

Index funds vs ETF summary

ETFs	Index Funds
Traded freely on an exchange	Usually purchased directly from provider
Doesn’t just hold baskets of stocks following indices	Holds only baskets of stocks following indices
Can invest with less money	Typically requires a larger minimum investment. Anything up to six figures is common
Buy and sell when you want	Limited to trading once per day
Sophisticated order types possible	Only buying and selling possible
Can’t make automatic investments or withdrawals	Can make automatic investments and withdrawals
Both actively and passively managed funds available	Limited to passively following indexes
Marginally higher costs	If there is a difference between an index fund and an ETF, the index fund will typically be slightly cheaper
Don’t pay as high a level of tax	Index funds are tax efficient. The taxes you pay are pretty low and beat most funds. However, ETFs are even more tax efficient

So which is better?

Now that we have got to the bottom of what they are and how they differ, the question then becomes: which one is better?

And I have to be honest, it’s not usually very clear. As you may have gathered by now they are both excellent vehicles to grow your wealth.

However, If I absolutely had the choice between investing in each I would probably go with an index fund. Heres why:

Why index funds are the best choice

In my opinion, where you can you should choose an index fund over an ETF because you can invest automatically. The power of this during bear markets and market crashes can’t be understated.

And though not always, it is often the case that index funds are just slightly cheaper than their exchange traded alternatives.

If your stockbroker / investment platform doesn’t provide index funds though, don’t worry about it. ETFs are still great. You just have to be a bit stronger mentally in down markets and expect to pay ever so slightly more although in some cases the extra tax efficiency may just even that out.

For long term investors the other differences will be marginal.

And by the way, it’s going to be easier to be stronger the more diversified you are. Investing in as broad an index tracking fund as possible is going to make most sense for most investors. And in turn you aren’t going to get much more diversified than a global index.

So if a crash comes just try to remember throughout history global stock prices as a whole have always recovered and reached new highs. All you needed was patience.

Why do index funds outperform active managers?

It’s worth going into a bit more detail on this active vs passive management malarkey as this is a concept that really seems counter intuitive when you first come across it.

When you think that a lot of these active mangers are exceptionally intelligent, highly talented, have access to all the best tools and equipment, are backed by some of the best teams in the world, possess plenty of money to invest in all the best research and latest technology and are highly experienced, why an earth do the vast majority of them fail to beat a simple index?

That’s vs an index that is basically just buying everything automatically. How can it be?

Here are some key reasons why index funds outperform

Active management fees

There are two main ways to invest. You can passively follow an index or you can actively manage your investments. Index followers don’t underperform or over perform. They simply get the average.

Now, on the other side of the coin are active managers, who decide to buy and sell stocks. Basically, they want to buy the ones they think will go up more and sell the ones they think will go up less.

This sound’s great in theory but here’s where it starts to unravel. If one of them wants to buy a stock then another one must sell that stock to them. After all, the indexers only buy and sell when the index tells them to, not when an active manager wants to trade. When you stop and think about it indexers are just bystanders looking on at what these active managers are doing.

When active managers trade, they do so with each other. In fact 99% of trading is done by institutional investors. This means when one manager buys shares of a company he thinks will go up, the chances are he’s buying from another manager that must think it will go down. One of these managers must be right and one of them must be wrong. They can’t both be right. The ones who got got it wrong will definitely underperform the average (that indexers get), but even those active managers that outperform their peers may struggle to beat indexers.

Think about it this way. If active managers spend all their time trading with one another then active management itself has to be a zero sum game. The overall results must be the same as the overall results gained by indexers. In other words if you split investors into two groups active managers and indexers, as a whole they’ll both get exactly the same returns. But there will be a big difference between what investors get because active managers charge higher fees to pay their own inflated salaries. Not to mention those of their teams, and all the other associated costs like offices, computers, research and the like.

Active management competence

Again, this will seem pretty counterintuitive, but the fact is active managers have improved beyond recognition. They are in fact some of the most highly educated talented people on earth. They have access to technology and expertise that wasn’t available even just a few years ago. The problem comes back to the fact that 99% of trades are done by professionals. It means these active managers are fighting amongst themselves!

Because they’ve all got the best education, the best resources and the best tools it is very difficult to beat them. Luckily indexers don’t have to. They leave them to use all their skills and cunning to fight each other and unfortunately for a lot of them the results aren’t pretty.

Active managers are the market. They are the ones who under or out perform the market. Indexers just get the average.

Job safety for financial professionals

With all this negatively aimed at active managers, you might think I don’t think it’s possible to beat an index fund or in turn the market, but that’s not the case.

Why? Well, people have done it. How much is down to luck and how much is down to skill is debatable, but the fact remains it can be done.

The guys who have had the most success at outperforming have tended to do something radically different to everyone else. Oftentimes, their funds loose massive amounts of money only to recover and reach new highs that handsomely beat the market in the end.

Attempting to beat the market is great, when in the end it pays off. It can turn a fund manager into a minor celebrity and make them incredibly rich.

But trying to beat the market can be lethal if you aren’t careful. Most investors aren’t patient when they start loosing money, particularly when they are paying higher fees.

Fund managers that loose too much money will find themselves out of a job. Arguing that the companies in their funds are primed for a revival simply won’t cut the mustard. Investors will move their money elsewhere and fund company bosses don’t like that at all.

Because of this lots of active managers end up investing in most of the same companies as the index. They will probably include a few differences to hide the fact. Perhaps allocating a bit more capital to one company than another or choosing to invest in a few companies that aren’t included on the index. Essentially though, they’ll be indexers too when you look close enough. The only real difference is that they’ll be charging you more money for their services.

But can we really blame them? Active managers have families and responsibilities too. A lot of them simply won’t risk doing anything radically different to an index because it may cost them their job.

When an active fund is similar to an index it follows that it will get similar results. Sometimes it might underperform by a little, but at other times it might over perform a little.

Sounds reasonable enough until you consider the fees again. Actively managed funds charge more and this needs to taken off their returns. And unfortunately for them, when fees are removed from returns they’ll probably end up underperforming even when before fees they out performed. And by the way, at all other times they’ll definitely underperform! They are fighting a pretty much unwinnable battle from the off.

But from an active managers point of view this underperformance will usually be fairly manageable. And most importantly a few percent of underperformance won’t get you fired. Doing this keeps their job safe. Food on the table and their kids in school. Can you really blame them?

Investing in a funny old world

It is a funny old world we live in. And stock prices reflect what is going on in this funny old world. If a pandemic occurs, lots of companies will suffer so share prices will go down. If a war breaks out in the middle east oil deliveries will be disrupted and the prices of oil company shares will shoot up.

But who knows when the next pandemic will cripple the world’s economies or when the next war will break out? And while we are on it, has anybody had any luck foreseeing the next tsunami? Do we think even one person can write anything resembling an algorithm to predict how greedy we humans can be next time financial markets begin bubbling over? Is it at all possible to measure the panic we are going to feel when the markets crash as they inevitably will do?

I think the short answer is, no! When push comes to shove, predicting what is going to happen in the world or markets is going to be pretty difficult at the best of times if not nigh on impossible.

Why do index funds work so well?

Buy the haystack

One of the best descriptions of stock picking and index funds comes from Bernard Malkiel in his seminal work ‘A Random Walk Down Wall Street.’ Malkiel is convinced looking for individual stocks or active managers that will be successful is like looking for a needle in a haystack so he says just ‘buy the haystack.’ In other words you just buy everything you can get your hands on. And the simplest, most effective, most tax efficient and cheapest way of doing this is by choosing the most diversified index tracking fund you can get your hands on.

Picture yourself investing £10K in the stock market 25 years ago. To ensure you didn’t put all your eggs in one basket, you divided your cash equally between the shares of ten companies. Unfortunately for you 9 of the 10 companies went bankrupt and your shares became worthless, but one managed to stay in business. If that one was Amazon your original £1K investment in Amazon would now be worth around £2 million. 90% of the companies you invested in went to zero but you still became a multimillionaire. Nice work if you can get it!

Now, in reality for the average person 10 companies won’t be enough to ensure you invest in the next Amazon, but don’t worry these days you can easily invest in funds that follow indices containing thousands of companies.

Of course, with thousands of companies, you’ll have thousands of stinkers too but here’s the key. You’ll guarantee you have the Amazons, the Apples, the Facebooks, the Netflixes, the Teslas too. And these will more than make up for the laggards.

Think about it this way. A company can only loose 100% of its value, where as it has the potential to grow infinitely. 500%, 2000%, 5000%, take your pick!

And think how good you’ll feel knowing you are practically invested in everything. When you invest in a share of a company, you essentially own a piece of that company. As the business makes more money, they’ll either reinvest it into the company itself which will increase the share price or they’ll pay out a dividend which you’ll receive directly into your investment account.

With broad global indices you’ll basically have tiny pieces of all the businesses that matter. Just imagine sitting in Starbucks sipping coffee, knowing that an incy wincy piece of the profit is going to your index fund. Then perhaps you send a message on your iPhone knowing full well that’s another one of the companies your fund contains. Then perhaps your friend turns up with the latest Samsung phone and starts telling you about her new Mercedes. You aren’t particularly interested in either of those companies products but you know your fund contains shares in both of them so deep down you thank your friend for lining your pockets with a tiny bit more money!

Essentially, when you invest in a fund that follows a global index the operation of the whole world around you will be contributing to your investment account. Even companies you don’t own will be doing business and buying things from companies you do own. Unless you are a hermit, you, your family, your friends, your work colleagues and acquaintances will constantly be contributing to your future.

Inbuilt filtering mechanism of an index

Lots of people mistakenly think you miss out on growing companies if you follow indexes but that’s not the case. If you invest in a highly diversified global index fund you’ll be invested in all the companies that matter. Some of these will be smaller and some will be bigger. Some of the smaller ones will grow rapidly into bigger ones and some of the bigger ones will shrink into smaller ones (and in some cases drop out of your index entirely).

Essentially, if you are invested in a highly diversified global index fund and it is like having a net or a filtering mechanism that catches all the smaller companies on their way up to the big time but lets through all the rubbish as they shrink to nothing.

Sure you’ll miss out on some of the very initial growth, but believe me going from the smallest in a global index to the biggest will provide more than enough gains for most.

Take Ashmore Group for example. Right now Ashmore Group is worth about $2 billion. I’ve no idea what they do or care really. I just wanted get an idea of the size of a typical smaller company in the FTSE All World index. It was the first small UK company beginning with A that I found. I couldn’t be bothered to move on to the Bs so there are probably a few smaller companies than this in the index.

Anyway currently Ashmore Group is worth about $2 billion. It sound’s pretty big to me, but compare that to the biggest company in the index, Apple which is worth $2.5 trillion. That’s 1250 times as much! I think we can rest assured that that there’s plenty of growth potential there.

Index Funds vs ETFs explained – the bottom line

If I was backed into a corner, I’d have to go with index funds for the simple fact that you can usually make all your investing automated. However, The difference between ETFs and index funds is marginal as long as your ETF follows an index.

Yes, there are differences, but as long as your ETF tracks one of the many indices out there, these differences won’t make or break your investment success. In short, your index fund vs ETF performance will be pretty much indistinguishable. Most investors will be well served with either.

Index funds and ETFs (that follow indices) aren’t just tax efficient, cheap and easy to invest in, because they hold the winners and get rid of the losers, they enable you to beat 90% of active managers.

Being globally diversified with a mix of stocks and bonds and investing in index funds (or ETFs) whenever you have free money for the long term is the recipe for success.