ETFs vs Index Funds: What is the difference?

ETFs vs Index Funds Key Takeaways:

• Both ETFs and Index Funds share the same investment strategy
• Differences in their structure provide ETFs with enhanced liquidity, transparency and trading flexibility
• New regulations enable ETFs to become the new go-to wrapper for all types of pooled investment vehicles

Starting with two fund structures: Passive ETFs and Index Funds

Over the past ten years, index-based investing has dramatically increased in popularity amongst investors. Passive investors can choose between two fund structures to invest: passive ETFs, nicknamed “trackers” also known as ETFs, and Index Funds. As they share a number of similarities, it’s important for investors to understand the differences.

Both passive ETFs and Index funds are collective investment vehicles and they both share the same investment strategy: to track a financial index as closely as possible. In that sense, they distinguish themselves from other forms of collective investment such as actively managed funds trying to beat a reference benchmark.

Not only do they share a common investment approach, but ETFs and Index Funds also share an important characteristic that all investors appreciate: low costs. By giving upon the pursuit of alpha (performance generated above that of a reference benchmark), index-based products keep the costs of research and trading extremely low. Moreover, passive mandates have the advantage of holding a relatively stable basket of assets for a long period of time. This allows the fund manager to engage in securities lending which helps generate extra income for the fund.  This income is passed on to investors and lessens the burden of the expense ratio.

Passive ETFs and Index Funds share many characteristics; but what distinguishes them? This article helps investors understand the differences between the two types of funds.

We detail three advantages passive ETFs possess over Index Funds (and all Mutual Funds more generally):

1. Extra liquidity
2. More trading flexibility
3. A higher level of transparency

ETF Advantage #1: Extra liquidity through the secondary market

ETF liquidity goes beyond the traditional Mutual Fund creation/redemption process as they can also be traded on exchange (hence the name “Exchange Traded Funds”). This is a unique characteristic that provides intra-day liquidity to ETFs investors – the ETF can be bought and sold at a live price any time the exchange is open.

The hybrid structure of ETFs, in-between a fund and equity, means they trade on both a primary and a secondary market. If there is insufficient liquidity on Exchange, or there is high demand for new ETF units, investors can turn to Authorized Participants (“APs” are often market makers, banks and other large financial institutions). APs ensure another layer of liquidity, by creating and redeeming ETFs shares to absorb the changing demand from investors.

By contrast, Index Funds are either open-ended or close-ended, but never both at the same time. This means investors can either go to the fund’s issuer or the market  but are not able to choose. As such their liquidity is much more constrained.

ETF Advantage #2: More trading flexibility with shares trading on exchanges

As ETFs are traded all day long on exchanges, they provide more trading flexibility to the investors. Indeed, investors can use various order types to execute the trade in the most efficient way for them. Order types range from common practises such as stop loss, limit or market orders, to more complex ones executed in dark pools. Not only are ETFs flexible on how they can be bought, they are also multiple options as to where they can be bought. Investors can trade across multiple exchanges as ETFs are often listed in more than one exchange, and also through various brokers. Large-scale institutional investors can also transact over the counter (“OTC”) in an effort to limit the price impact of a large trade.

On the other hand, investors in Index Funds have no choice but to transact at the end of the day NAV – an unknown price based on the closing value of the fund.

Finally, ETF shares can also be lent or used as collateral which provides even more flexibility in the hands of investors, something that is not possible with Index Fund shares.

ETF Advantage #3: A higher level of transparency with daily disclosures and intraday valuation

Another major advantage of ETFs compared to Index Funds is their enhanced transparency. Through either the ETF provider or third-party platforms such as Trackinsight, investors in ETFs can get full transparency on the constituents of an ETF. This level of transparency allows investors to understand precisely what they are buying, and can potentially highlight overlapping exposures between two funds within investors’ portfolios.

Regulations require that an ETF’s holdings and weights are published daily, while Index Funds are more flexible, and most of them provide their holdings and weights on a much less frequent schedule, usually monthly or quarterly.

Other than getting a precise knowledge of their investments, the improved transparency of ETF benefits investors in another way as it has a direct impact on price discovery. Transparency allows financial data vendors to provide almost real time indicative value of the fund (called indicative Net Asset Value or iNAV). This gives all market participant a better picture of the true value of the fund at any given time, allowing them to trade the fund at a price close to its intrinsic value. By comparison, open-ended Index Funds only have their NAV published once per day after market close. This continuous ETF valuation is extremely important as it increases market efficiency and enables investors to lessen their risk of potential discounts/premiums when they build or exit their positions.

ETFs vs Index Funds: Conclusion

For the past decades, the asset management industry has witnessed a significant shift from actively managed products to index-based solutions. These products have become a favourite amongst investors and AUM has soared in both passive ETFs and Index Funds.

While they share a similar investment strategy, passive ETFs and Index Funds differ substantially. The ETF structure provides a number of advantages to end investors, such as additional liquidity, transparency, and trading flexibility.

Even though ETFs were made famous for replicating indices, the T in the acronym does not stand for “Tracker”. The advantages of ETFs listed in this article are still valid outside of the index-based world and a similar comparison can be done between actively managed ETFs and active Mutual Funds.

Read more:

• What is an ETF?
• A brief history of ETFs

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