There are five key differences between exchange traded funds (ETFs) and index funds that every investor should know in order to make wise decisions.

The differences include how both are traded, priced, what they cost, their functionality and, last but not least, tax efficiency, states G.E. Miller at 20 Something Finance.

  • Index funds are mutual funds which are purchased from the fund management company. They are not traded on the open market throughout the day and can only be purchased at the end of the closing day.  As for ETFs, they are priced through a broker and are traded throughout the day.
  • Index funds are priced based on the fund’s net asset value (NAV), whereas NAV is used to evaluate ETFs, but market conditions cause prices to fluctuate throughout the day.
  • Regarding costs, index funds charge a fee to get into the fund, loads charged by the fund company, and ongoing expense ratio. ETFs charge brokerage fees and an expense ratio, which is much lower than that of an index fund.
  • Index funds generally have less functionality than ETFs. When buying or selling an index fund, it is done at the end of the trading day, leaving an investor ambiguous about how the fund’s daily reaction will be toward current market conditions and often, these funds have high minimum and subsequent investment amount, making them limiting. ETFs, on the other hand, are traded like stocks, and offer several options, like limit orders and short selling.
  • Mutual funds generally hit investors with capital gains taxes at the end of each year, regardless of whether or not one sells shares.  Capital gains are generally rare with ETFs, taxes are imposed only when an ETF is redeemed at a profit, ETFs offer long-term capital gains rates, and ETFs allow taxpayers to use gains to offset losses, enabling the investor to be in more control of tax implications.

All investors should consider the pros and cons of all investment options before jumping into a position. 

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.