Passive investing continues to become more popular, and the number of funds available to investors has exploded. While passive investments might seem quite similar, they can be very different.
To help shine some light on passive investing, we’ve highlighted some differences between index funds and ETFs.
This article isn’t personal advice. If you’re not sure if an investment is right for you, ask for financial advice. Investments rise and fall in value, so you could get back less than you invest.
What exactly are index funds and ETFs?
Both are typically passive investments that let investors access stock markets by tracking an underlying index, like the FTSE 100. However, there are nuances that separate them.
When you buy or sell an index fund, the price is based on the total value of all securities held within the fund, also known as the net asset value (NAV). Index funds only value and trade once a day, usually at midday. Unlike ETFs, investors won’t know exactly what price they’re buying or selling for until after the trade’s taken place.
ETFs on the other hand are funds traded on a stock exchange, like shares, and are a type of Exchange Traded Product. They can still track an underlying index, but the price of ETFs will fluctuate through the trading day. While being able to trade ETFs throughout the day makes them more flexible, it’s never a good idea to try time the market – that’s something even the experts tend to avoid.
Index funds are typically single priced, meaning the buy and sell price is the same. Whereas ETFs have different buy and sell prices, known as the offer and bid. The difference between the buy and sell price is called the bid/offer spread. A small bid/offer spread means investors are getting a market price close to the NAV. These spreads are managed by market makers, a designated broker-dealer company that tracks an ETF’s NAV throughout the day.
There can be occasions where an ETF’s market price might not match the NAV. If the ETF’s market price is above the NAV, it’s trading at a ‘premium’. If it’s below, it’s at ‘discount’. This doesn’t happen with index funds. These price discrepancies can occur when:
- Markets are fluctuating more dramatically (e.g. at market open or close)
- The underlying holdings trade infrequently (e.g. bonds or emerging market shares)
- The underlying holdings trade at different hours than the stock exchange
How easy are they to trade?
When you place an instruction to buy or sell an index fund, the process is overseen by the fund manager and doesn’t require any other participant in the market (a broker for example). This usually means that your trade instruction is likely to be accepted without any issues.
ETFs are traded like shares, so you’re relying on someone in the market wanting to take the other side of your trade. While this is unlikely to cause any issues, during periods of low trading activity, you could run into difficulties trading ETFs if you can’t find a buyer/seller.
Which one is safer?
One isn’t safer than the other. It all depends on what the fund owns. For example, an ETF invested in emerging markets would normally be considered riskier than one investing in developed markets, like the US. Or an index fund holding stocks might be considered riskier than one holding bonds.
How much will they cost?
Both index funds and ETFs have annual management charges that are paid to the company offering the investment. Because they’re typically both passive investments, they usually have lower annual management charges compared to actively managed counterparts (ones that try to beat a benchmark instead of track it).
There aren’t any charges to buy and sell index funds on our platform, but there are for ETFs. As they’re treated and traded like shares, both a buy and sell instruction for an ETF will be subject to HL share dealing charges. The difference in dealing charges can be important when deciding if an index fund or ETF is right for a portfolio.
Our platform charge of up to 0.45% per annum also applies for index funds held in any account. This charge will also apply to ETFs held in an HL ISA (to a maximum of £45 per year) and those held in the HL Self-Invested Personal Pension (SIPP) (capped at £200 per year). There’s no platform charge for holding ETFs in the HL Fund and Share Account.
Here’s a summary of the key points for investors:
| Index Fund | Exchange Traded Fund | |
|---|---|---|
| What do they track? | Underlying Index | Underlying Index |
| How do they trade? | Trade like a fund | Trade like a share |
| Pricing | NAV of the underlying investments | Bid and offer price based on underlying investments |
| When are they priced? | Once a day | Continually throughout the day |
| Trading costs | No dealing costs | HL share dealing costs (£5.95 - £11.95 per deal if done online) |
| Holding charge in a HL account | Up to 0.45% per annum | Up to 0.45% per annum (capped at £45 in an HL ISA and £200 in an HL SIPP). No charge for holding them in a HL Fund and Share Account |
| Initial investment | Minimum of £100 lump sum or £25 through the regular savings plan | No minimum investment. However must buy at least one share |
If you’re interested in learning more about index funds and ETFs, take a look at our Knowledge Centre.