?Indexed funds vs. ETFs What’s better?

Indexed funds or ETFs? This is a question that every passive investor will end up asking sooner or later.

Active management has been losing ground to passive management because passive management is easier and more traditional banks and neobanks are starting to offer it.Aside from rs-roboadvisors, index funds and ETFS are the two tools for passive investing.

The philosophy and essence of an index fund and an ETF are similar: replicating indices (or sectors). There are differences in its operation and taxation that will favor one or the other depending on your needs and what you want in your portfolio.

Indexed funds: what they are and how they work

Indexed funds have as their ultimate goal to replicate the behavior of a given index as accurately as possible, including both bullish and bearish movements. This is where the main difference lies between actively managed funds and indexed funds.

While actively managed funds seek to achieve higher returns than those of the market, index funds try to obtain the same return as their benchmark. It is a simpler and more economical philosophy in terms of commissions and costs.

Because of this, indexed funds don’t need a management team, so they have much lower management fees and generally need less money to start investing than active management funds.

For the rest, its operation is the same as that of an active investment fund, both at the level of negotiation and operation.

As for taxation, they have the same privileges as active management funds. That is, transfers can be made from some funds to others, and only the profits are taxed after the sale of the shares. This is one of its advantages over ETFs, as we will see later.

Here are some examples of indexed funds:

ETFs: what they are and how they work

ETFs, or exchange-traded funds, are another class of funds called quoted funds. They are also intended to replicate a certain index. However, they differ from index funds in that ETFs are listed on the stock market, and therefore, for practical purposes, they work like stocks.

That is, ETF trading is done on the stock exchange, so that they can be easily bought and sold during the hours when the market is open, not only at the closing of the same, as is the case with an indexed fund.

The replica made by ETFs can be made in two ways:

• Physical replica: this type tries to replicate a stock market index in an identical way. For example, if an ETF physically replicates the IBEX 35, it must be composed of shares of the same companies that make up that index in the same proportion. What’s better? etf versus mutual fund That is, the weight of the shares that make up the portfolio has the same weight in the ETF as it does in the IBEX 35.
• Synthetic replica: this case is somewhat more complicated since the ETF’s portfolio is not formed by the purchase of the shares that make up the index but by investments made through derivatives (swaps) and agreements with the other party. This type of replication is very common in low-liquid markets where there are difficulties in selling or buying shares easily, as may be the case in emerging markets.

Physical replica ETF vs. synthetic replica ETF: how they differ

Like index funds, ETFs lack a management team and also enjoy low costs and commissions. In this sense, its costs may be lower than those of an index fund and are usually below 0.5% in many cases.

In addition, since they are securities that are listed on the stock exchange, they do not have a subscription fee, while indexed funds can have one. Of course, when quoting its cost structure, it can include the typical expenses of a stock, and you will need a broker to buy and sell ETFs.

Here are some examples of ETFs:

Differences between indexed funds and ETFs

After learning how index funds and exchange-traded funds duplicate stock indices, it’s time to compare them.
What makes each one stand out when building your indexed portfolio

Operational and flexibility

An investment fund works as a fund, and an ETF works as an option. This difference affects its liquidity and flexibility, giving a slight advantage to the listed fund. And both are very liquid investments, but the ETF is a little more so.

With an indexed fund, you can give the purchase or sale order at any time, and it will be executed at the close of the market. In other words, until the end of the day, you will not know exactly the purchase or sale price because that is when the value of the shares in the fund is calculated.

With an ETF, you will know everything instantly. In addition, the sale of your investment will be made at this moment. This is a point of speed that can be key depending on your investment strategy or in times of great falls, for example.

Number of indexed funds and ETFS

Are you looking for variety? The number of ETFs is much higher than that of indexed funds. In addition, they are much more varied.

Most indexed funds replicate stock indices such as Ibex 35 or some global indices such as MSCI World. With them, you can create a very well-diversified indexed portfolio without problems.

However, if you want to be exposed to more specific areas, sectors, commodities, or management styles, you will have to resort to ETFs. ETFs are much more versatile, and with them you can invest in specific sectors, countries that index funds do not replicate, What’s better? etf versus mutual fund and a much wider variety of assets.

In short, with ETFs, you can go as far as an index fund will not take you.

Commissions and costs

There is one thing you should be clear about: both ETFs and index funds are economical investment tools with reduced costs. Now, is an index fund or an ETF cheaper?

One of the differences between ETFs and index funds is the cost that each one has. A fund has the characteristics of an investment fund, and a listed fund has those of a share.

An indexed fund has a subscription, refund, and custody cost, as well as a low management charge

For its part, investing with ETFs also entails a management fee, to which you must add the buy-to-sale commissions imposed by the broker.

If we refer only to the management fee, those of ETFs are cheaper than those of index funds. Specifically, the cost of the ETF can reach 0.3%, although it is normal for it to be lower,What’s better? etf versus mutual fund even less than 0.1 percentage points. With an index fund, it is very rare that you pay less than 0.15%, and there are those that will charge up to more than 1%.

Taxes

Here lies the real heart of the issue for the Spanish passive investor. The main distinction between the two is that an index fund is taxed as a fund, whereas an ETF is taxed as a stock.

This means that with an indexed fund, you will not have to pay taxes if you transfer the money to another fund (whether or not it is indexed). What’s better? etf versus mutual fund This is one of the benefits of index funds, and it makes rebalancing the portfolio much easier.

By using indexed funds, you will not be taxed on the accumulated profit when you readjust the percentages of your portfolio or transfer money from a fund that no longer interests you to a new one.

With an ETF, you will have to pay tax for all these changes. ETFs work as shares on your income tax return, and any sale you make will involve paying taxes, even if it is to invest in another ETF.

How much does this mean for practical purposes? In financial terms, the difference is to reinvest with each change or rebalance between 19% and 26% of the accumulated profits. This can mean a small pinch or a big blow, depending on how and how often you rebalance your indexed portfolio.

Conclusions: Is an index fund or an ETF better?

The battle between index funds and ETFs over who will be the dominant player in passive management is a fact. For some time now, ETFs have been eating into the market share of index funds, thanks in large part to the wide variety of ETFs that we can find in the market.

ETFs can invest in niche stocks like marijuana and AI, whereas indexed funds cannot.
Intraday operations can also be performed while buying and selling fund shares at the closing net asset value.

The advantage of index funds is their simplicity in terms of operation; however, they usually have slightly higher commissions than ETFs, although with these you have to take into account the commissions per operation that the broker will charge us in the purchase and sale of ETFs.

However, if we follow the philosophy of passive management—buying and waiting—those brokers’ commissions will, in absolute terms,What’s better? etf versus mutual fund  be lower than the management fees of indexed funds.

Also, if we look at the end goal of passive management,

which is to make a copy of a certain stock index, ETFs usually make better copies.

However, ETFs also have disadvantages compared to index funds. They are primarily taxed more favorably than index funds.ETFs work as stocks and therefore are taxed in the same way. That is why, through ETFs, we do not have the opportunity to make transfers without previously taxing our capital gains.

As always, it depends on the operation, but ETFs’ fiscal disadvantage favors index funds

In conclusion, if your intention is to invest in specific sectors, ETFs are our product, and we will have much more variety to choose from. If your investment replicates the most popular stock market indices, the tax advantage of the indexes will offset the somewhat higher commission

In any case,

it is also not essential to choose between one and the other. ETFs and indexed funds are fully compatible. What’s better? Mutual vs. ETF
For example, you can utilize index funds for most of your indexed portfolio to rebalance without thinking about Treasury and ETFs to reach certain sectors. You can also access these two vehicles through a roboadvisor.