ETFs and index funds explained
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If you’re not sure how exchange traded funds (ETFs) differ from index funds, you’re probably in the majority (and you’re in the right place to find out more). ETFs and index funds offer similar features, such as tracking the performance of the stock market, but can be bought and sold differently. On this page, we explain what ETFs and index funds are, how they differ and the pros and cons of these types of investments.
Tracking: ETFs and index funds are similar because they help you track a specific financial market or sector, such as the stock market.
How they’re bought: ETFs and index funds can be bought and sold differently. Like every fund, you can buy and sell ETFs and index fund shares directly from the fund managing company, but with ETFs you can trade shares on the stock market as well, giving you more flexibility.
Passive management: ETFs and index funds are passively managed. This means you don’t have to invest in a fund manager and can therefore cut out some of the cost.
What are ETFs and index funds?
ETF stands for exchange traded funds, and is a type of investment fund that allows you to purchase a number of individual securities in one single transaction.
This means that when you make a purchase, you’re buying a wide variety of assets. These assets might include things like stocks in various companies, or commodities such as gold and crude oil.
ETFs are passively managed funds that track a specific index. This index might represent a particular industry, a basket of commodities or even an entire economic sector.
Index funds are similar to ETFs in that they’re a passive product designed to mimic the performance of a financial index. Their goal is to simply track rather than beat the market as well.
Both ETFs and index funds potentially allow you to benefit from a market’s long-term growth. Because they’re passively managed, they require minimum input. Unlike actively managed products such as mutual funds, you don’t have to research specific investments. This can save you time and hassle, as actively managed products require market research.
What’s the difference between ETFs and index funds?
The main difference between ETFs and index funds is the way they’re bought and sold. You can make ETF trades throughout the day, whereas with an index fund, you’re restricted to buying or selling until the prices are set at the end of each trading day.
This makes ETFs slightly more liquid, meaning it’s easier to convert your asset back into cash and vice versa.
Pros and cons of ETFs and index funds
As ETFs and index funds are both passively managed funds, the pros and cons for each product are broadly the same. It’s therefore more helpful to consider the advantages and disadvantages of passive funds as a whole.
Pros
Low cost – ETFs and index funds tend to require minimal management, which in turn typically means their fees are lower than other investment options.
Low maintenance – passive investment products like ETFs and index funds require minimal effort, making them ideal for investors who are time-poor or don’t want to pay for a fund manager.
Tax-efficient – passive products such as ETFs and index funds may be more tax-efficient due to their ‘buy and hold’ strategy, which means you’ll incur less capital gains tax than those who actively invest.
Cons
Not usually suitable for short-term investing – passively managed funds essentially mirror market performance, which means you most likely won’t see any quick benefits or returns. It’s worth considering ETFs and index funds as long-term investments.
Lower potential rewards – passive products can never beat the market because they simply mimic the index they’re invested in. In theory, actively managed products might have a chance to beat the market. However, research has indicated that this is rather unlikely in the long run.
Should I consider a savings account instead?
If you don’t want to take any risks on your investments but want guaranteed returns, then choosing a savings account such as a fixed rate bond may be a better option for you. A fixed rate bond offers a competitive interest rate that doesn’t change from the day you open the account until the end of your fixed term, so you’re guaranteed a return on your savings.
You can quickly and easily open a savings account with Raisin UK by registering and applying today. Opening an account with Raisin UK is free, and offers competitive interest rates from a range of UK banks.
*https://www.moneyadviceservice.org.uk/en/articles/hedge-funds
**https://www.nytimes.com/topic/company/galleon-group
***https://www.fca.org.uk/firms/aifmd