Exchange Traded Funds vs Index Funds

 

Researching all the available options for you as a first-time investor is a critical step that shouldn’t be missed. Even if you end up paying a third party to manage your investments, you will need to understand how they will invest on your behalf and what to expect from them.

Investment funds such as exchange traded funds (ETFs) and index funds are a popular choice for those new to investing. Learn more about how they work, their advantages and disadvantages so that you can decide on the best investment strategy for you.

What are investment funds?

An investment fund is a pool of money which is professionally managed on behalf of investors. Investment funds are used by investors large and small, including multi-billion dollar superannuation funds all the way to individual investors. 

Each investment fund will have an investment objective that will dictate what type of investments it will hold (for example only Australian shares or European government debt) and how it will measure success. Investment funds are a popular choice for investors, especially those investing for the first time.

Why would I choose an investment fund over buying individual shares?

If you decide to manage your own share investment portfolio, you have to dedicate time and energy to know what to invest in and maintain your portfolio. This includes formulating your own investment strategy, knowing which shares to buy, managing portfolio risk, ensuring proper diversification, and rebalancing occassionally – all of which require research and planning.

If you cannot dedicate the time required to research and actively manage your investment portfolio, an investment fund may be an alternative worth considering.

What are Managed Funds?

A managed fund is one type of investment fund where your money is pooled together with other investors. An investment manager is appointed to then make the decisions as to which particular securities to buy, hold, rebalance and sell in order to try to achieve the investment objective of the fund.

There are several types of managed funds. There are actively managed funds where the investment manager aims to ‘buy low and sell high’ in the hope of  outperforming the index to which the fund’s performance is benchmarked. 

The fees for active management tend to be higher than index funds or exchange traded funds, and active managers rarely beat the market year after year, especially after taking higher their fees into account.

The alternative to actively managed funds are passively managed funds that aim to track the performance of the index to which they are benchmarked, such as exchange traded funds and index funds.

What are Exchange Traded Funds (ETFs)?

Exchange Traded Funds (known as ETFs), are a type of a managed fund listed on the stock exchange and traded like shares. They track an asset or market index (e.g. ASX200, the Australian share index).

ETFs generally do not try to outperform the market they are investing in, and hence their performance will closely mirror the index they are tracking.

What are Index Funds?

Index funds are similar to ETFs in that they track a market index and tend to be low cost. Where index funds are different is that they can’t be traded throughout the day like ETFs and publish an end of day value, typically known as Net Asset Value (NAV).

They also tend to have a paper based application and redemption process. Because of the way ETFs are structured, ETFs tend to be more tax efficient than a traditional index fund.

What is the difference between ETFs and Index Funds?

Though they are both similar, there are key differences between ETFs and index funds, as we highlight in the table below:

Pros Cons
Exchange Traded Funds
  • Low fees
  • Broad exposure to the stock market
  • Full Transparency – Majority of ETFs disclose their full holdings every day
  • Easy to buy and sell
  • Tax efficient
  • Choosing right ones can be hard
  • Cheaper than managed funds, but still include fees
Index Funds
  • Low fees
  • Broad exposure to the stock market
  • Higher fees than ETFs
  • Harder to buy and sell

Why Clover chooses ETFs

At Clover, we’re advocates for low-fee, index-based investing using exchange traded funds. ETFs are a great way to facilitate this type of investing, and we’re proud to offer ETFs as the basis for all of our investment recommendations.

If you’re interested in learning more about how to grow your wealth with ETFs, click here for your free investment plan.

Disclaimer


Also published on Medium.