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Index funds vs ETFs – what’s the difference and why should you care?

We look at some of the key differences between index funds and exchange traded funds (ETFs).

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

As interest in passive investing continues to grow, so does the variety of tracker options available. While passive investments might all look to do the same thing, they can actually be very different.

To help shine some light on passive investing, we’ve highlighted some differences between two major groups of passive investments, index funds and ETFs.

Investing isn't right for everyone. Investors should only invest if the investments’ objectives are aligned with their own, and there's a specific need for the type of investment being made. Investors should understand the specific risks before they invest, and make sure any new investment forms part of a diversified portfolio.

What exactly are index funds and ETFs?

Both are 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 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 not even the experts can do.

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 respectively. The difference between the buy and sell price is called the bid/offer spread. A small bid/offer spread means the investors are achieving 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 is said to be trading at a ‘premium’, below it would be called a ‘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.

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 both passive investments, they usually have lower annual management charges compared to their actively managed counterparts (ones that try to beat a benchmark instead of track it).

Transaction costs for index funds are zero on the HL platform, but this isn’t the case for ETFs. As they’re treated and traded like shares, both a buy and sell instruction for an ETF will be subject to the HL share dealing charges. The difference in dealing charges can be an important consideration 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 a HL ISA (to a maximum of £45 per year) and those held in the HL 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 Help and Support page.

This article isn’t personal advice. If you’re not sure if an investment is right for you, ask for financial advice. All investments and any income from them can fall as well as rise in value, so you could get back less than you invest.

Investing in active and passive funds – when and how to blend them in a portfolio? 

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Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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