I know a lot of people – beginning and advanced investors alike – have questions about index funds and ETFs (which, by the way, are great investment options for passive investors, especially when combined with a dollar-cost averaging strategy.)
So here are two short videos explaining what an index fund is and what an ETF is:
Should you choose an index fund or an ETF?
That decision really comes down to a few things. Be sure to ask yourself these questions before you buy:
1. Which index fund or ETF best represents your investing goals?
There are tons of ETFs on the market. Be sure to find one that best represents your investing style. There are ETFs that track specific industries, sectors, and even sub-sectors. Some are market cap weighted and some are equal weighted. Be sure to do your research to find the best ETF that represents your goals.
2. Which has a lower expense ratio?
Most ETFs and index funds can be owned for a fraction of a percentage point. Still, there are some ETF and index funds that charge too high a price. Generally speaking, you can find almost any high quality fund with an expense ratio under 0.5%. If you find an ETF charging more than that, I highly recommend you do some more research to ensure that is the right one for your portfolio.
3. What are the transaction costs involved?
This used to be a bigger deal in the past. Nowadays, most brokerages do not charge commissions on buying and selling. How lucky we are!
If you are still using a brokerage that charges trading commissions, I highly suggest you find a zero commission broker. Check out our reviews on some great free brokerages like Webull and M1 Finance.
4. What are the tax implications?
Some index funds and ETFs are more tax friendly than others. This mainly has to do with which type of businesses are in the fund. This topic is beyond the scope of this article, but be sure to do some research regarding tax friendly asset allocation.
A Good Strategy
Lastly, if you’re wondering what the best investment strategy is for “small investors who don’t have time to research individual companies”, I’ll leave you with this quote from Warren Buffett:
“The best [strategy] in my view is to just buy a low-cost index fund and keep buying it regularly over time, because you’ll be buying into a wonderful industry, which in effect is all of American industry. If you buy it over time, you won’t buy at the bottom, but you won’t buy it all at the top either… People ought to sit back and relax and keep accumulating over time.”
What is an index fund?
A fund is simply a group of smaller investments you buy in a single package. An index is just a measure of a financial market. So an index fund is a fund that mirrors a certain index. For example, the S&P 500 Index measures the stock performance of the 500 biggest companies in the U.S. You can buy an S&P 500 index fund from firms like Vanguard, Fidelity, or Charles Schwab that tracks the S&P 500 – giving you exposure to the stock performance of the 500 biggest companies in the U.S.
What is an ETF?
An ETF, or exchange traded fund, is a fund that trades on a stock exchange – just like the stock of Google or AT&T. As a consequence of being on an exchange, ETFs offer more liquidity than index funds (you can buy and sell ETFs during the day; you can only buy and sell index funds at the end of the day), which is perhaps the biggest difference between index funds and ETFs.
ETFs also offer lower minimum purchase requirements (you can buy as little as one share of an ETF; index funds sometimes have minimum purchase requirements of $3,000-$50,000 or more) and sometimes have lower expense ratios. There is also a more diverse universe of ETFs that you can choose from.