Index funds and Exchange Traded Funds (ETFs) are passively managed. Unlike traditional mutual funds, a fund manager or an asset management company doesn’t continuously customize an individual portfolio’s day-to-day assessment and performance. But why is there such a large gap between their prices?
Index funds are so expensive and tend to be more expensive than ETFs because of their higher entry thresholds and expenses. Also, most index funds incur intermittent capital gain tax, which is non-existent in the case of ETFs unless you sell your shares.
Index funds and ETFs have more similarities than differences. However, the differences can have a significant impact on the net return on investment. All investors should weigh the potential net returns on index funds and ETFs regardless of exposure and financial objectives. In this article, I will help you identify and understand these differences so that you can make an informed investment choice for your investment goals. So, let’s begin!
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Table of Contents
Factors That Make Index Funds More Expensive Than ETFs
A specialist doesn’t actively manage index funds. However, a fund manager is involved at the end of day assessment of the net asset value (NAV). The same fund manager or a team also works on and facilitates the buying and selling of assets among investors.
In contrast, ETFs have no such intervention.
There’s a Minimum Investment for Buying Index Fund
It’s unnecessary for a mutual fund to have an entry threshold, whether actively or passively managed. Investors should have the liberty to buy as little as a single share or the lowest fund unit.
However, asset management companies have minimum initial investment amounts to meet their targets. Index funds often have an entry threshold. Take the Vanguard 500 Index Fund Admiral Shares (VFIAX) as an example. The initial minimum investment is $3,000.
Many investors, especially younger adults with limited capital, may find the minimum investment criterion a steep ask.
Index Funds Carry Higher Expenses Than ETFs
Index funds carry a lower expense ratio than those of actively managed portfolios, but their expense ratio is still higher that of an ETF. The S&P 500 Index Fund of Vanguard cited above has an expense ratio of only 0.04%.
In contrast, the average expense ratios can be anywhere between 0.40% to more than 1% per year for actively managed mutual funds, depending on the type. The expense ratio applicable for index funds doesn’t include all costs.
Other typical costs are front-end loads, back-end commissions, and 12b-1 fees.
In most cases, front-end and back-end commissions are excluded. The 12b-1 fee may or may not be included in the expense ratio. You have to check this for every fund and your chosen asset management company.
These costs can cumulatively increase the net expenses on your investment. Since an index fund isn’t traded intraday, you’ll bear the expenses without immediate or short-term return.
Index funds are long-term investment options that investors hold for a while. Higher recurring costs without any significant appreciation of the assets will dent the net return on the initial investment.
Index Fund Investors Have To Pay Intermittent Capital Gain Tax
Ideally, an investor should pay a capital gain tax only after selling an asset and earning a profit. While dealing in index funds, an investor may not sell anything but the more extensive program might need reallocation of assets and resources.
A fund manager may facilitate buying and selling stocks among investors, causing a capital gain for others not directly involved in the transaction.
Many investors share an entire index fund. Any transaction within and with the fund effectively affects the value of the assets owned by every investor. A positive change in the net asset value leads to a capital gain.
Thus, an investor has to pay capital gain tax despite not having sold anything or even granting permission to the fund manager to carry out the causal transaction.
Index fund managers don’t operate in a way that leads to net losses for investors. Hence, you won’t get a capital gain tax notice now and then. Besides, index funds aren’t traded like ordinary stocks.
However, there could be a few instances every year when a tax is imposed, thereby increasing the costs of owning an index fund.
In a nutshell, index funds are expensive due to a considerably high initial investment amount, greater recurring expenses every year, and the unexpected capital gain tax imposed on transactions not initiated or pursued by an individual investor.
In rare cases, the capital gain tax may apply even if a fund is undergoing overall depreciation, and as an investor, your net asset value has declined.
Factors That Make ETFs Cheaper Than Index Funds
ETFs are a type of mutual fund, albeit passively managed, and operated like equity stocks.
You can trade an index fund only at the end of a trading day after the fund manager assesses and declares the net asset value. ETFs allow intraday trading based on the real-time value of the shares.
ETFs Have Low Entry Threshold
ETFs don’t have any minimum investment amount criterion, as you may choose to invest in only one share or a single unit of stock. The price of this unit becomes your entry threshold. The absence of an initial qualifying investment of several hundred or a few thousand dollars automatically enables younger investors with limited capital to consider ETFs.
Let’s use the same Vanguard 500 Index Fund Admiral Shares (VFIAX) example cited earlier. The index fund has an ETF version known as Vanguard S&P 500 ETF (VOO), which doesn’t require any minimum initial investment. You can buy only one share or a hundred if you want.
ETFs Have Lower Expenses Than Index Funds
ETFs have a lower expense ratio than index funds. Usually, an ETF doesn’t require a fund manager for daily assessments to calculate the net asset value after the close of trading. The annual expense ratio for Vanguard S&P 500 ETF is 0.03%, which is 0.01% lower than the applicable fee for its index fund version.
Many asset management companies and brokerage service providers don’t charge a fee when investors purchase ETFs. Thus, the front-end load is offset completely.
For instance, Vanguard Brokerage Services don’t charge any commission on either a purchase or a sale of ETFs. ETFs trade all day like any regular stock. Real-time prices are available for anyone who wishes to buy or sell.
The intervention of a fund manager or any specialist is unnecessary.
Investors can trade ETFs whenever they want throughout a trading day, provided there’s a willing counterparty.
ETFs Only Involves a One-Time Capital Gain Tax
ETFs are taxable for capital gains, and it is applied when an investor sells an ETF and earns a profit. No intermittent capital gain happens since a fund manager doesn’t trade an ETF as part of the larger mutual fund pool.
Hence, no tax is applicable for any investor participating in the program.
ETFs have the lowest expense ratios and no minimum investment criterion. The front-end commission is often waived. Some companies don’t charge brokerage fees on the purchase and sale of ETFs.
Investors pay a one-time capital gain tax after selling an ETF for a profit.
Index Funds vs. ETFs
Index funds are better for the long term, while exchange-traded funds are more suited for investors looking for intraday trading opportunities and more liquidity. However, ETFs may not have ready buyers when you want to sell, so that shackles the promised liquidity through the provision of intraday trading.
Index funds are bought or sold after the net asset value is assessed. Investors can easily find buyers through their dedicated index fund managers.
There are other technical, financial, and implied differences between the two. The costs are only a fraction of the entire premise of index funds and ETFs. So, don’t forget to consider the entire landscape of your investment goals, before making a decision between the two.
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Conclusion
Neither index fund nor ETF is designed to outperform or outwit the market. Instead, these passively managed mutual funds are intended to mirror the benchmarks to generate a relatively safe return for investors, however modest or generous, in the midterm to the long run.
Index funds have a higher expense ratio in comparison to their corresponding ETFs. However, expenses are just one of the many parameters that you should consider when choosing between these two instruments. Liquidity, for example, should be an important consideration for this decision.
To learn more about ETFs and Index Fund, be sure to check out more of my articles on them. I have plenty of those here, and I am sure you will find answers to most of your investment questions here on TradeVeda!
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