Index Funds vs. ETFs: What's the difference?

What are index funds, and how do they work?

An index fund is a type of mutual fund, which are sometimes referred to as investment funds.

Mutual funds pool assets like bonds, stocks, commodities, and real estate into one “basket”, allowing individual and institutional investors to buy shares of the funds. A portfolio manager manages these assets and charges a fee for doing so. Information regarding these fees can be found in the Get a quote section on the NBDB online brokerage platform, under the heading Key quote info and the subheading Management fee.

Index funds are different from other mutual funds. In some cases, index funds are composed of stocks from all the companies that make up a specific stock market index. As a result, the value of an index fund mirrors the performance of the underlying index, called the benchmark index.

An index is one of the ways investors track and gauge market performance. Since the index fund replicates the movement of the underlying benchmark index, it will neither outperform nor underperform the benchmark. The goal of an index fund is to replicate the risk and provide a return that matches the benchmark index. 

Index funds are considered passively managed investments. Unlike actively managed mutual funds, where portfolio managers try to outperform the benchmark by timing the market and making strategic investment decisions, index funds simply follow the market. 

As a result, an index fund offers investors a well-diversified investment with lower management fees than actively managed mutual funds. This makes index funds appealing to cost-sensitive investors. 

Advantages of index funds

Some of the advantages of index funds include:

• Diversification - By investing in an index fund, you gain exposure to a broad range of assets within a specific market, providing instant diversification across various sectors and industries.
• Low management expense ratios (MERs) - The MER is the percentage an investor pays out for the management of the mutual fund. In addition to management fees, MER includes operating expenses and taxes deducted from your return. Index funds generally have lower MERs than actively managed funds, though they may be slightly higher than those of ETFs.
• Low minimum investment - Depending on the index fund, minimum investments typically range between $500 and $1000, making it accessible to a wide range of investors
• Automatic investing - Most index funds offer the option to set up automatic contributions, making it easy to regularly add to your investment over time.

Disadvantages of index funds

Some of the disadvantages of index funds include:

• Lack of flexibility - Since index funds are passively managed, they strictly follow their benchmark index, meaning they likely won’t outperform it. In contrast, actively managed funds have the potential to capitalize on opportunities to outperform the benchmark and limit losses during market downturns.
• Not for the short term - Index funds, like other mutual funds, are not suitable for short-term trading or short holding periods. Withdrawing your money before the end of the term can result in paying a penalty.
• Not fully invested - Index funds typically hold some cash to accommodate withdrawal requests, meaning a portion of your investment isn’t always fully invested in the market.
• No protection from market downturns - Since index funds mirror their benchmark index, they are vulnerable to market downturns. Without active management, there’s no strategy in place to mitigate losses during declines.

How to start investing in index funds?

Investing in index funds in Canada is straightforward and a great way to build a diversified investment portfolio. Here are the steps to follow:

1. Choose an index fund: Research and select a fund that tracks an index aligned with your investment goals.

2. Open a brokerage account: If you don’t already have one, open a brokerage account or investment account. Many financial institutions and online brokers in Canada offer index funds, with some, like National Bank Direct Brokerage, providing low fees and 0$ commission on online mutual fund transactions.

3. Invest: Once your account is set up, decide how much you want to invest and purchase units or shares of the index fund.

How does an index work?

Indices serve as a benchmark to evaluate the performance of the market or a portion of the market. While you can’t directly invest in indices like the DJIA or S&P 500, you can purchase index funds or ETFs that replicate their asset composition and weighting. There are hundreds of different kinds of indices, including broad market indices, indices for a specific market segment, bond indices, and specifically constructed benchmarks. Popular examples include the Standard and Poors 500 (S&P 500), the Dow Jones Industrial Average (DJIA) or the Standard, and the Poors/Toronto Stock Exchange Index (S&P/TSX).

An index is a hypothetical portfolio of investment holdings representing a segment of the financial market. Most indices are market-cap weighted, meaning companies with higher market capitalizations of the company - a measure of the total value of a company - have greater influence on the index’s performance. 

However, there are exceptions, such as the Dow Jones Industrial Average (DJIA), which is price-weighted. In this case, the stock with the highest share price, rather than the largest market capitalization, holds the most weight in the index and has the highest impact on the index's value.¹

What are exchange traded funds?

An exchange traded fund (ETF) is a security that trades on an exchange and consists of a basket of diversified securities. Like mutual funds, they can be actively or passively managed. A passive ETF typically tracks and replicates the movement of an index like the TSX, the S&P 500, or a specific sector such as biotech or oil and gas.

Each ETF share represents partial ownership of the underlying pool of holdings. ETFs are popular due to their low fees compared to similar investment products, making them an affordable and convenient way to invest in the market. Additionally, unlike mutual funds, ETFs can be traded like stocks during market hours, offering flexibility for both short-term and long-term investors.

Explore the features of our ETF Centre

Advantages of ETFs

• Flexibility - ETFs are highly liquid and can be traded throughout the day, unlike mutual funds, which are priced only at market close.
• Versatility - Since ETFs trade on an exchange like stocks, investors can use limit and stop-loss orders when buying and selling ETFs, giving them more control over their trades.
• Diversification - Like index funds, ETFs can offer exposure to a broad market or specific sector, providing instant diversification. 
• Lowest MERs - Some index ETFs offer management expense ratios (MERs) as low as 0.005%, making them appealing to fee-conscious investors. 
• Low minimum investment - ETFs typically have a minimum purchase requirement of just one unit, making them accessible to investors with smaller budgets.

Disadvantages of ETFs

• Limited returns - Since passive ETFs track an index, their returns will rarely outperform the benchmark. This is different from actively managed funds, where portfolio managers aim to outperform the market or limit downside risks in periods of market weakness.
• Commissions - Some online brokers charge commissions for the purchase or sale of ETFs. For frequent traders and investors purchasing in smaller increments, fees and commissions can quickly add up and eat into profits. However, at National Bank Direct Brokerage (NBDB), all online stock and ETF transactions are subject to a 0$ commission.
• No automatic investing - Unlike index funds, ETFs don’t offer automatic contribution options, requiring manual purchases. 

Index Fund vs. ETFs: What’s the difference?

While index funds and ETFs share many similarities, some of the differences may make one more appealing depending on your investment style. 

Index funds are ideal for investors who prefer a hands-off approach and appreciate the convenience of automatic contributions, which is not available with ETFs. As a result, an investor looking to invest smaller amounts regularly might gravitate towards an index fund. Index funds are also well-suited for long-term investors who aren’t concerned with intraday trading.

On other hand, ETFs tend to appeal to investors making larger, less frequent purchases — such as once a year — because of their lower MERs. ETFs also offer greater flexibility, as they can be traded during market hours with no minimum investment requirement and are subject to lower expense ratios. As a result, ETFs are a good option for investors seeking more control over their investments while minimizing costs. 

Both index funds and ETFs offer self-directed investors a diversified, low-cost way to invest in the market. They are valuable components of a well-rounded investment portfolio. However, it’s important to remember that all investments carry some risk. Be sure to do your research, take advantage of available tools and resources, and make informed decisions to help you reach your financial goals!