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It’s important for passive investors to understand the difference between an exchange-traded fund (or ETF) and an index fund, which is a type of mutual fund. The terms are often used interchangeably, but in reality, they mean very different things. This article will compare the differences and similarities between an ETF vs. index fund.
Difference between ETF and Index Fund
There are a few main differences between ETFs and index funds (which are often invested through a mutual fund). First, ETFs can be traded more easily compared to traditional mutual funds and index funds. They can be bought and sold on an open exchange like regular stock, whereas mutual funds are priced at the end of the day. It's why they're considered to be more flexible and convenient than index funds.
Also, it's possible to buy ETFs in smaller sizes and it's less of a hassle to buy them compared to mutual funds. For mutual funds, there can be more documentation and special accounts required.
The other big difference between ETFs and index funds is cost. For index mutual funds, there's no shareholder transaction cost. However, taxation and management fees tend to be much lower for ETFs. Looking at the cost comparisons, most passive investors opt for index funds over ETFs. In contrast, passive institutional investors tend to prefer ETFs.
Despite their differences, both are considered passively investment strategies, designed to track the performance of other assets.
ETF vs. Index Fund: Key Facts
Here are some key facts to know about ETFs vs. index funds:
- ETFs and index funds are similar in one way: they each contain a basket of securities that track a specific market index.
- Index funds can be purchased through a bank or an online brokerage, but there is no charge for buying and selling the funds. This makes them ideal for small, frequent contributions.
- ETFs trade on a stock exchange and can be bought and sold during normal trading hours. Index funds are priced at the end of the day.
- ETFs can be purchased through a discount brokerage account, many of which charge fees to buy and sell. Look for a discount brokerage like Questrade that offers free ETF purchases.
- ETFs come with a significantly lower management expense ratio than index funds, with ETF MERs typically less than 0.25% compared to 1% or less for index funds.
- The best robo advisors in Canada can build you a managed portfolio of index funds and ETFs aligned to your risk tolerance and that is automatically rebalanced.
- Both are considered a passive investing strategy.
All About Exchange-Traded Funds
ETFs are a collection of stocks, bonds, or other investments that you buy and sell as a fund. In this way, ETFs are similar to mutual funds, but with one big difference: they track the performance of a specific market or index.
What does that mean? There is no fund manager behind the scenes, selecting investments in the fund and trying to beat the market. Instead, an ETF holds all the investments in a particular region (such as Canadian or US equities), sector (such as energy or technology) or index (such as the S&P 500) and strives to match that market’s overall performance.
Another main difference between an ETF and an index fund is that ETFs can be traded more easily, just like stocks on a market exchange like the TSX or S&P 500. They're listed on market exchanges and can be bought and sold like stock shares during trading hours, with prices going up and down throughout the day.
Advantages of ETFs
Here are some of the advantages of buying ETFs:
- Less Risk: You’re not relying on a fund manager to pick and choose “winning” investments and time the market. Instead, your investment returns are based on overall market returns.
- ETFs (Usually) Mean Lower Fees: Even though there may be fees associated with buying and selling ETFs, investors can save big on the MER, or the management expense ratio. ETFs typically charge much less than mutual funds and even index funds. For instance, Vanguard’s Canada All Cap Index ETF (VCN) charges a minuscule 0.06% MER. Index ETFs give investors access to a wide variety of sectors and styles, with products focused on dividends, technology, small companies, REITs, Gold, and everything in between.
- All-in-One ETF Solutions: ETFs come in a variety of flavours and the most recent addition to the menu is something called an asset allocation ETF. Think of this product as a balanced ETF where an investor can get global stock and bond diversification with just one fund. Vanguard, iShares, BMO, and Horizons all offer these products with various asset mixes for conservative and aggressive investors. The fees range from 0.18% to 0.25% MER.
Downsides to ETFs
ETFs are not for every investor. Many brokerages charge a fee of $9.99 to buy and sell ETFs, and so they’re not ideal for beginner investors who make small, frequent contributions. For example, if you’ve just set up $100 bi-weekly contributions to your RRSP, you might be better off investing in index mutual funds, since it does not cost anything to buy and sell mutual funds.
Some investors who favour dividend-paying companies might want to build their own portfolio of dividend-paying stocks, replicating an index, to get the stocks they want while avoiding the costs of an ongoing MER.
Where to Buy ETFs
An ETF investor will need to open a discount brokerage account to make trades. New investors might not want to bother opening a discount brokerage account until they have a significant amount – say $25,000 or more – to invest.
Because they’re traded on an exchange, most brokerages charge a fee to buy and sell ETFs. Check out our ultimate guide to Canada's discount brokerage and you'll find the brokerages that offer free ETF trades – including Questrade, our favourite discount brokerage.
All About Index Funds
An index fund is a type of mutual fund that tracks a specific market index, such as the S&P 500. It holds all the stocks and bonds of a particular market and represents a theoretical segment of the market. These can be small or large companies, companies separated by industry, and so forth. Like ETFs, it's considered a passive investing strategy — it screens what stocks will be included and then tracks the stocks without trying to “beat them.” Because not as much active management is needed, index funds cost less than traditional mutual funds.
The rise of index funds stems from the United States, where Vanguard founder John Bogle pioneered the first index mutual fund for retail investors in the 1970s. Instead of trying to beat the market like most actively managed mutual funds, index funds simply track the market and mimic its performance.
The main difference between an index fund and an ETF is that mutual funds are not bought and sold on an open exchange like ETFs. They’re priced at the end of the day. Another difference is that investors don't pay a fee to buy and sell mutual funds. There's no need to open a discount brokerage account to invest in index funds. Investors can buy index funds through their bank, either online or through an advisor.
Advantages to Index Funds
Here are some of the advantages of buying index funds:
- Ideal for Small Investors: Since they can be purchased for free, index funds are not only ideal for small investors but also for investors who make frequent contributions. A general rule is to invest in index mutual funds until you’ve reached a threshold of say, $25,000, and then open a discount brokerage account and switch to index ETFs.
- Cheaper than Active Mutual Funds: While index funds don’t have as low of an MER as index ETFs, they are still much cheaper than the typical actively managed mutual funds sold by banks and retail investment firms. The average MER on an equity mutual fund in Canada is more than 2%, while index mutual funds typically cost less than 1%. That said, Canadian banks are loath to sell index funds through their advisor channel – with many anecdotal stories from investors saying their advisor didn’t even know the funds existed! TD e-Series funds are a prime example. Lauded for their low cost and strong performance, a portfolio of 3-4 TD e-Series funds can be built with an MER of around 0.40%. But these funds can only be purchased online with TD, either through TD mutual funds or TD Direct Investing.
Downsides to Index Funds
Here are few downsides to index funds:
- Less Choice, More Complicated For Consumers: There is less product diversification in Canadian index funds, with only Tangerine Mutual Funds offering an all-in-one balanced index fund. The cost of these funds is on the high side, at 1.07% MER.
The Hybrid Option
I've explained the difference between ETFs and index funds, and how do-it-yourself investors can purchase these products on their own to build a portfolio. However, with the advent of robo-advisors, investors no longer have to use a human advisor (which might cost 2% MER or more), or go it alone.
With a robo-advisor like Wealthsimple, you can get a managed portfolio of index funds and ETFs that is tailored to your risk profile and is automatically monitored and rebalanced. Simply pay a low management fee between 0.40% to 0.50%, along with the MER of the underlying investments held in your portfolio (another 0.20% or so), and you've got your own hands-off, professional investment portfolio. As a special offer for Young & Thrifty readers, sign up for Wealthsimple and get your first $10,000 of assets managed free for one year.
ETF vs. Index Fund: How to Choose?
My general rule is this: index funds are best for new investors who are just starting to build their portfolio. They’re ideal for small, frequent contributions because there’s no cost to buy and sell.
As your portfolio grows to $25,000 and beyond, open a discount brokerage account and switch to ETFs. Index ETFs are cheaper to own than index mutual funds, and give investors more options to choose from.
Regardless of whether you decide to buy an ETF or index fund, your best bet is to go with one of the best online brokerages in Canada that cuts fees to the bare bone. What we love about Questrade is that it offers some of the lowest-cost options in Canada, and Young and Thrifty readers who open an account get $50 in free trades.
If you prefer a less hands-on approach, a robo advisor like Wealthsimple can build you a balanced, diversified portfolio of ETFs and index funds for a low-cost. Our top choice is Wealthsimple, where Young and Thrifty readers get their first $10,000 of assets managed free for one year.
So now that you’re in the know, are you ready to get started? Go for it!
RELATED: If you enjoyed this article, here are some others that you may like:
- What is ETF Investing
- What Is An Index Fund?
- The Value of Value Investing
- What is Swing Trading?
- How to Start Investing in Canada
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