It’s important for passive investors to understand the difference between an exchange-traded fund (or ETF) and an index fund, which is a type of mutual fund. The terms are often used interchangeably, but in reality, they mean very different things.
The ins and outs of indexing
Before we dive into the differences, let’s talk about the common characteristics of index funds and index-tracking ETFs – both passive investing strategies. The case for passive investing is compelling. An overwhelming amount of academic research and empirical evidence shows that passive investing through low-cost index funds or ETFs outperforms actively managed investment strategies over the long term.
Index investing passively tracks a market index (like the S&P 500) and captures its returns, minus a small fee. By staying invested and capturing market returns, investors are all but guaranteed to outperform an active manager who tries to pick and choose “winning” investments and time the market. Instead, your investment returns are based on those of the overall market.
Another similarity between ETFs and index funds relates to tax efficiency. Unlike in the U.S., most ETFs in Canada are treated exactly the same as mutual funds when it comes to paying taxes on capital gains and withholding tax on foreign dividends.
Main differences between index funds and ETFs
There are a few key differences between ETFs and index funds (which are often invested through a mutual fund). First, ETFs can be traded more easily than traditional mutual funds and index funds. They can be bought and sold on an open exchange like regular stocks, whereas mutual funds are priced at the end of the day. It’s why they’re considered to be more flexible and convenient than index funds.
Also, it’s possible to buy ETFs in smaller amounts and it’s less of a hassle to buy them compared to mutual funds. For mutual funds, there can be more documentation and special accounts required.
The other big difference between ETFs and index mutual funds is cost. For index funds, there’s no shareholder transaction cost. However, taxation and management fees tend to be much lower for ETFs. Looking at the cost comparisons, most passive investors opt for index funds over ETFs. In contrast, passive institutional investors tend to prefer ETFs.
Despite their differences, both are considered passive investment strategies, designed to track the performance of other assets.
Advantages of ETFs over index funds
Here are some of the advantages of buying ETFs over index funds:
Lower fees (usually)
Even though there may be fees associated with buying and selling ETFs, investors can save big on the management expense ratio, or MER. ETFs typically charge much less than mutual funds and even index funds. For instance, Vanguard’s Canada All Cap Index ETF (VCN) charges a minuscule 0.06% MER. Index ETFs give investors access to a wide variety of sectors and styles, with products focused on dividends, technology, small companies, real estate investment trusts (REITs), gold, and everything in between.
All-in-one ETF solutions
ETFs come in a variety of flavours and the most recent addition to the menu is something called an asset allocation ETF. Think of this product as a balanced ETF where an investor can get global stock and bond diversification with just one fund. Vanguard, iShares, BMO and Horizons all offer this type of product with various asset mixes for conservative and aggressive investors. The fees range from 0.18% to 0.25% MER. Index mutual funds don’t typically come in the same all-in-one package, so investors need to own multiple funds to build a truly diversified portfolio.
Greater flexibility to buy and sell
ETFs are traded throughout the day on an exchange, just like stocks. That means greater liquidity for investors, who can buy or sell their ETF units any time markets are open. Index mutual fund trades are all settled at the end of the day at the net asset value of shares at the market close, so investors cannot lock in their price until that time.
With an ETF, investors can use limit and stop orders during trading hours to ensure whenever they buy or sell they can get the best price for their investment.
Downsides to ETFs
ETFs are not for every investor. Many brokerages charge a fee of $9.99 to buy and sell ETFs, and so they’re not ideal for beginner investors who make small, frequent contributions. For example, if you’ve just set up $100 bi-weekly contributions to your RRSP, you might be better off investing in index mutual funds since it does not cost anything to buy and sell mutual funds.
Some investors who favour dividend-paying companies might want to build their own portfolio of dividend-paying stocks, replicating an index, to get the stocks they want while avoiding the costs of an ongoing MER.
Where to buy ETFs
For ETF investing, you will need to open a discount brokerage account to make trades. New investors might not want to bother opening a discount brokerage account until they have a significant amount – say $25,000 or more – to invest.
Because they’re traded on an exchange, most brokerages charge a fee to buy and sell ETFs. Check out our ultimate guide to Canada’s discount brokerage and you’ll learn more about how to buy and sell investments in the most cost-effective way. You can also find brokerages that offer free ETF trades – including Questrade.
The hybrid option
I’ve explained the difference between ETFs and index funds, and how do-it-yourself investors can purchase these products on their own to build a portfolio. However, with the advent of robo-advisors, investors no longer have to use a human advisor (which might cost 2% MER or more), or go it alone.
With a robo-advisor like Wealthsimple, you can get a managed portfolio of index funds and ETFs that is tailored to your risk profile and is automatically monitored and rebalanced. With Wealthsimple, simply pay a low management fee between 0.40% to 0.50%, along with the MER of the underlying investments held in your portfolio (another 0.20% or so), and you’ve got your own hands-off, professional investment portfolio.
Advantages of index funds
Here are some of the advantages of buying index funds:
No commissions
The main advantage that index funds have over ETFs is that there are no commissions or transaction costs to buy and sell mutual funds.
Ideal for small investors
Since they can be purchased for free, index funds are not only ideal for small investors but also for investors who make frequent contributions. A general rule is to invest in index mutual funds until you’ve reached a threshold of $25,000, for example, and then open a discount brokerage account and switch to index ETFs.
Cheaper than active mutual funds
While index funds don’t have MERs as low as those for index ETFs, they are still much cheaper than the typical actively managed mutual funds sold by banks and retail investment firms. The average MER on an equity mutual fund in Canada is more than 2%, while index mutual funds typically cost less than 1%. That said, Canadian banks are loath to sell index funds through their advisor channel. (In fact, many anecdotal stories from investors say their advisor didn’t even know the funds existed.) TD e-Series funds are a prime example. These funds can only be purchased online with TD, through TD mutual funds, or TD Direct Investing. Lauded for their low cost and strong performance, a portfolio of three to four TD e-Series funds can be built with an MER of around 0.40%.
Downsides to index funds
There are some downsides to index funds.
Less choice, more complicated for consumers
There is less product diversification in Canadian index funds, with only Tangerine Mutual Funds offering an all-in-one balanced index fund. The cost of these funds is on the high side, at 1.07% MER.
More expensive to manage
The ongoing management fee, or MER, for index mutual funds, can be considerably more expensive than a similar portfolio of index ETFs.
Think of it this way: A $100,000 portfolio of index funds may cost 0.50% per year, or $500 to manage. The same portfolio of index ETFs could cost as low as 0.10% per year, or $100 to manage. That’s $400 of potential savings in your pocket each and every year.
ETF vs. index Fund – key facts
Here are some key facts to know about ETFs vs. index mutual funds:
- ETFs and index funds are similar in one way. They each contain a basket of securities that track a specific market index.
- Index funds can be purchased through a bank or an online brokerage, but there is no charge for buying and selling the funds. This makes them ideal for small, frequent contributions.
- ETFs trade on a stock exchange and can be bought and sold during normal trading hours. Index funds are priced at the end of the day.
- ETFs can be purchased through a discount brokerage account, many of which charge fees to buy and sell. Look for a discount brokerage like Questrade that offers free ETF purchases.
- ETFs come with a significantly lower management expense ratio than index funds with ETF MERs typically less than 0.25% compared to 1% or less for index funds.
- The best robo-advisors in Canada can build you a managed portfolio of index funds and ETFs aligned to your risk tolerance and that is automatically rebalanced.
- Buying ETFs or index funds is considered a passive investing strategy.
ETF vs. index fund: How to choose
My general rule is this: index funds are best for new investors who are just starting to build their portfolios. They’re ideal for small, frequent contributions because there’s no cost for buying and selling.
As your portfolio grows to $25,000 and more, open a discount brokerage account and switch to ETFs. Index ETFs are cheaper to own than index mutual funds and give investors more options to choose from.
Regardless of whether you decide to buy an ETF or index fund, your best bet is to go with one of the best online brokerages in Canada – one that cuts fees to the bare bone.
If you prefer a less hands-on approach, a robo-advisor can build you a balanced, diversified portfolio of ETFs and index funds for a low cost.
So now that you’re in the know, are you ready to get started? Go for it!
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