ETFs Versus Index Funds

ETFs, or exchange-traded funds, have grown in popularity since they were first introduced in 1993. These flexible investment vehicles can be described as index funds that are traded similar to stock shares, and they both follow the performance of an index. There are ETFs for commodities and currency, along with leveraged and actively managed ETFs. Many investors often ask themselves whether they should use ETFs or index mutual funds.

Fees and Commissions
ETFs are sold in whole shares while index funds can be purchased in fractions. Another difference between ETFs and index funds is that ETFs are bought and sold through a broker. ETFs are traded on an exchange, similar to stocks, and can be bought or sold any time. Brokers charge a commission on the purchase or sale of an ETF, whereas no commission fees are needed for index funds. Index funds can only be bought once a day from a certain fund.

This commission should encourage investors to place large amounts of capital within an ETF rather than small amounts to get the most for that fee. Experts recommend that for investors who frequently readjust their portfolios, ETFs may not be the most appropriate investment vehicle. On the other hand, unlike index funds, they don't feature a minimum investment amount, so investors can purchase as little or as much as desired.

The Tax Impact
Another reason why investors like ETFs is that they often offer more tax efficiency with lower capital gains. When an investor chooses to cash out a fund, capital gains are result. Investors must pay taxes on any capital gains from either an ETF or an index fund, but gains from ETFs are generally minimal.

Cash Drag
Another difference between an ETF and an index fund is that an ETF never needs to maintain a portion of its portfolio in cash, a feature quite common with index funds. If part of the portfolio is in cash, then it might not achieve as high a return compared to an ETF. It is this reason that investors sometimes choose ETFs, because they have less "cash drag" than index funds.

In general, if you are want an investment that tracks an index and you like to buy and sell regularly, an ETF might be a better bet. If you are more interested in sticking with one investment and avoiding fees, go with index funds.

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