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

October 28, 2024 by National Bank Direct Brokerage

Index funds and ETFs (exchange traded funds) are two of the most popular investment products available to investors looking for diversified, low-cost options. But what sets them apart, and how are they similar? In this article, we'll dive into key differences and benefits, helping you understand which investment solution may suit your investment style. Whether you are a new or seasoned self-directed investor, gaining a deeper understanding of these investment vehicles can empower you to make more informed financial decisions.

A smiling man investing in index funds and ETFs using his computer.

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

Skip embedded content

Transcript

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!

Interested in learning more about index funds and ETFs?

    • Start by exploring our in-depth articles, available in our Learning Centre.
    • Take advantage of the investment tools and resources available on our online brokerage platform to build an investment strategy that fits your goals.
    • Consider attending our educational webinars to deepen your understanding of these investment options.

    Ready to start investing in index funds and ETFs?

    Key takeaways

    • An index fund is a type of mutual fund that holds a basket of securities and replicates the composition of a specific index, such as the DJIA or S&P/TSX.
    • Indices are used by investors to track and gauge market performance.
    • An exchange traded fund (ETF) is a security that trades on an exchange and consists of a basket of diversified securities.
    • Most ETFs and index funds are passively managed, meaning they aim to match, not outperform, their benchmark.
    • Both investment vehicles are effective for diversifying portfolios and generally have low management expense ratios (MERs), making them cost-effective compared to actively managed funds.
    • ETFs trade throughout the day, while index funds can only be traded at the end of the day.
    1. Wright, Dorsey. Understanding the DJIA: How Price-Weighted Index Performance Attributions Differ From Cap-Weighted. Nasdaq. 12 juin 2020.

    Continue your learning

    The little details that matter

    Explore the features of our ETF Centre

     

    Exchange traded funds are investment vehicles that combine the benefits of mutual funds with the flexibility of shares and low management fees.  With thousands of Canadian and US listed Exchange Traded Funds to choose from, where can an investor begin.

     

    In this video National Bank Direct Brokerage, will introduce you to our ETF Center that can be used to help you find Exchange Traded Funds. Once signed into your NBDB account, you can access the section via the markets heading, and then select ETF Center from the drop-down menu.

     

    The screener tool will help you create a list that meets your specific criteria. The first step is choosing whether you want Canadian or US dollar denominated Exchange Traded Funds.  

     

    For today I’ll stay with the default option which is Canadian. Now by hovering your cursor over general information, a drop-down menu will appear showing you some of the criteria and with three categories already selected for you to start your search.  

     

    Many investors will also screen their selection by management fees, so let’s click on that box as well. 

     

    To the right we have fund data where you can add a return filter to screen out negative returns or set a minimum return. 

     

    If we scroll down, we have the ETF type broken down into active or passive. Below we have some different asset classes or categories that an investor can select from. 

     

    Our next category is classification, which by clicking on add criteria, provides you with a list of 40 additional selections shown in alphabetical order that allow you to further refine your search.

     

    For our example, let’s select High Dividend Yield, and then click here to register our choice. Below we have the management fee, that we selected earlier, let’s go with those that have a fee of 50 basis points or less.

     

    Now as we were customizing our criteria on the right-hand side of the page, the ETF Center was providing a list of search results for each category and if we scroll down to the screener results, we have a total of 34 results to work with.

     

    The default view highlighted here is based on our selected criteria, with the symbol, name, the market cap which is the assets under management. Next to it we have the type, the class, the classification and finally the management fee. 

     

    You can also view the results using the fund info, where they’ve added the previous day’s closing price or by the performance. Now if you place your cursor over an ETF symbol a pop-up will appear with additional information for you to consult. 

     

    If we click on the symbol, you will be redirected to our quotes section where you can get a real-time quote, as well as key quote information on the Exchange Traded Fund. 

     

    If we scroll down, on the left, we have the cumulative returns, and the average annualized returns shown over multiple periods. You can also view the top 10 holdings, and their overall weighting and below we have the sector, and geographic weights.

     

    Now if we head back to the ETF Center, I’m going to show you a report that can help you find or select an Exchange Traded Fund. We will click on ETF Research and then click on Research & Strategy which is provided by National Bank Financial.

     

    There are many reports here, but specifically we will look at, Exchange Traded Funds Canada & U.S. This report is updated a few times a year and basically takes a snapshot of all Canadian and U.S. listed Exchange Traded Funds and has organized them by category. 

     

    For example, we have emerging markets, different thematic themes, ESG equity. Lower down we have high yield bond, in the fixed income category, and if you wanted exposure to gold, silver or oil we have a commodity section. Lastly there is a multi-asset and crypto asset category as well. 

     

    Now let’s say we wanted to explore the thematic equity section of this report, simply click the heading and we will slightly scroll down and here we have several lists of themes to review. Just a few examples to look at such as agriculture, cybersecurity, infrastructure, innovation and others.

     

    At the top of each page, you will find useful information on the ETF, such as the ticker, name, MER and even the dividend yield. Some clients prefer using this option to help them find potential Exchange Traded Funds.

     

    As you can see by using our ETF Center, with just a few clicks you can quickly sort and focus your research on those that meet your investment goals. This ends our video on our ETF Center please join us for a second video on how to compare multiple Exchange Traded Funds using our comparison tool.

    The articles and information on this website are protected by the copyright laws in effect in Canada or other countries, as applicable. The copyrights on the articles and information may belong to the National Bank of Canada, its subsidiaries or other persons. Any reproduction, redistribution, communication by telecommunication, including indirectly via a hyperlink, or any other use thereof that is not explicitly authorized, of all or part of these articles and information, is prohibited without the prior written consent of the copyright owner.

     

    The content of this Web site is provided for general information purposes and should not be interpreted, considered or used as if it were financial, legal, fiscal, or other advice in any way. In addition, the information presented on this Web site, whether financial, fiscal or regulatory, may not be valid outside the province of Quebec.

     

    This article is provided by National Bank Direct Brokerage (NBDB) for information purposes only. It creates no legal or contractual obligation for NBDB and the details of this service offering and the conditions herein are subject to change.

     

    The hyperlinks in this article may redirect to external websites not administered by NBDB. NBDB cannot be held liable for the content of external websites.

     

    Views expressed in this article are those of the person being interviewed. They do not necessarily reflect the opinions of NBDB.