Exchange-traded funds, or ETFs, and index funds are very popular with investors today. Both offer advantages over mutual funds. that are actively managed. The question of including them in your investment portfolio largely depends on whether they suit your personal investment style, strategy, and goals.
- ETFs and index funds generally have lower fees compared to actively managed mutual funds.
- Historically, index funds have outperformed actively managed mutual funds.
- However, a handful of actively managed mutual funds offer significantly higher returns compared to index funds, which lack the flexibility to earn above-market averages.
What is an index fund?
Index funds are mutual funds designed to reflect the performance of a market index such as the S&P 500 Index. Because it essentially duplicates the movements of its index, an index fund can be passively managed. In other words, no fund manager has to make active decisions about where and how to invest.
The two main advantages of passively managed index funds over actively managed mutual funds are: (1) lower management expense ratios (.71 actively managed fund vs. .06 index fund in 2020), and (2) the fact that that index funds have historically outperformed most actively managed funds.
However, there are some actively managed funds that generate significantly higher investment returns than index funds. The main disadvantage of index funds is the lack of flexibility that automatically prevents them from making dramatic gains above the average market performance.
What is an ETF?
An ETF is an equity investment. Built to track a commodity, index, market sector, or basket of assets, it is a fund that is traded in the same way as an individual stock. That is, their price changes throughout the day as shares are bought and sold, while mutual fund shares are priced once a day. ETFs have exploded in popularity with investors since their emergence at the investment stage in the 1990s.
Comparing ETFs to mutual funds involves several factors, but among the notable advantages, ETFs offer the following:
- Because they can be traded like stocks, ETFs offer the advantage of being more liquid. They can be bought or sold at any time during business hours. They are more flexible. They can be sold short. They can also be bought on margin, bought with limit orders, and hedged with options.
- ETFs have lower management fees.
- They are more favorable when it comes to taxes. Rather than buying and selling portfolio assets, which would create a taxable event, ETFs generally require Authorized Participants to redeem shares in kind. This avoids day-to-day redemption costs incurred by funds and minimizes capital gains taxes.
- ETFs are more accessible to small investors because they allow the purchase of individual stocks, while many mutual funds have minimum investments of $ 2,500 or more.
- ETFs provide easier access to alternative investments, creating a broader range of investment opportunities. There are ETFs that invest in commodities and currencies, offering the ability to invest extensively in international and emerging markets.
One drawback of ETFs is that they cannot reinvest dividends like mutual funds can.
Comparison of ETFs and index funds
Index funds are generally better suited for less sophisticated and more risk-averse investors who have longer-term investment horizons. For example, those who use investing in stocks as part of a retirement plan and prefer to keep things simple, minimize investment costs and seek reasonable returns, benefiting from the historical trend of stock values to increase with the weather.
ETFs are more attractive to investors with more practical investment styles, those who aggressively seek higher short-term returns on investments, and sophisticated investors who want greater access to alternative investments such as the forex and futures market.