Understanding ETFs vs. Index Funds

ETFs vs. Index Funds: An Overview

Exchange-traded funds (ETFs) have become increasingly popular since its inception in 1993. But despite investors’ love affair with ETFs, a closer look shows that index funds are still the top choice for the majority of retail index investors. Here we will look at the reasons why ETFs have become so popular and analyze whether they make sense—from a cost, size, and time-horizon standpoint—as an alternative to index funds.

As with many financial decisions, determining which investment vehicle to commit to comes down to the numbers. Given the comparison of costs, the average passive retail investor will decide to go with index funds. For these investors, keeping it simple can be the best policy. Passive institutional investors and active traders, on the other hand, will likely be swayed by qualitative factors in making their decision. Be sure you know where you stand before you commit.

ETFs

Because ETFs are flexible investment vehicles, they appeal to a broad segment of the investing public. Passive investors and active traders alike find ETFs attractive.

Passive institutional investors love ETFs for their flexibility. Many see them as a great alternative to futures. For example, ETFs can be purchased in smaller sizes. They also don’t require special documentation, special accounts, rollover costs, or margin. Furthermore, some ETFs cover benchmarks where there are no futures contracts.

Active traders, including hedge fund traders, love ETFs for their convenience because they can be traded as easily as stocks. This means they have margin and trading flexibility that is unmatched by index funds. Ironically, ETFs are exempt from the short sale uptick rule that plagues regular stocks (the short sale uptick rule prevents short sellers from shorting a stock unless the last trade resulted in a price increase).

Index Funds

Passive retail investors, for their part, will love index funds for their simplicity. Investors do not need a brokerage account or deposit with index funds. They can usually be purchased through the investor’s bank. This keeps things simple for investors, a consideration that the investment advisory community continues to overlook.

Key Differences

ETFs and index funds each have their own particular advantages and disadvantages when it comes to costs associated with index tracking (the ability to track the performance of their respective index) and trading. The costs involved in tracking an index fall into three main categories. A direct comparison of how these costs are handled by ETFs and by index funds should help you make an informed decision when choosing between the two investment vehicles.

First, the constant rebalancing that occurs with index funds because of daily net redemptions results in explicit costs in the form of commissions and implicit costs in the form of bid-ask spreads on the subsequent underlying fund trades. ETFs have a unique process called creation/redemption in-kind (meaning shares of ETFs can be created and redeemed with a like basket of securities) that avoids these transaction costs.

Second, a look at cash drag—which can be defined for index funds as the cost of holding cash to deal with potential daily net redemptions—favors ETFs once again. ETFs do not incur this degree of cash drag because of their aforementioned creation/redemption in-kind process.

Third, dividend policy is one area where index funds have a clear advantage over ETFs. Index funds will invest their dividends immediately, whereas the trust nature of ETFs requires them to accumulate this cash during the quarter until it is distributed to shareholders at end-of-quarter. If we were to return to a dividend environment like that seen in the 1960s and 1970s, this cost would certainly become a bigger issue.

Non-tracking costs can also be divided into three categories: management fees, shareholder transaction costs, and taxation. First, management fees are generally lower for ETFs because the fund is not responsible for the fund accounting (the brokerage company will incur these costs for ETF holders). This is not the case with index funds.

Second, shareholder transaction costs are usually zero for index funds, but this is not the case for ETFs. In fact, shareholder transaction costs are the biggest factor in determining whether or not ETFs are right for an investor. With ETFs, shareholder transaction costs can be broken down into commissions and bid-ask spreads. The liquidity of the ETF, which in some cases can be material, will determine the bid-ask spread.

Finally, the taxation of these two investment vehicles favors ETFs.

ETFs can rid themselves of capital gains inherent in the fund by transferring out the securities with the highest unrealized gains as part of the redemption in-kind process.

Special Considerations

Typically, the choice between ETFs and index funds will come down to the most important issues: management fees, shareholder transaction costs, taxation, and other qualitative differences.