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ETFs vs index funds: What are the key differences?

Posted By The Accumulator On In Passive investing,Updated | 64 Comments

Should you choose an ETF or an index fund? What features really matter? In this post, we’ll help you cut to the chase on ETFs vs index funds by focussing on the differences that count. See our table just below for a quick summary. 

You may well already know that index funds and Exchange Traded Funds (ETFs) are both types of investment funds that are ideal for passive investing [1]. 

Collectively known as index trackers [2], ETFs and index funds invest your money – along with that of thousands of other people – into particular asset classes and segments of the market, such as UK equities or global bonds. 

Both index funds and ETFs track an underlying index of securities such as the FTSE 100 or the S&P 500. Investing in a defined market like this enables trackers to capture investment returns like a solar panel converting the energy of the sun.  

From a big picture perspective, ETFs and index funds share the same benefits. Namely they are:

So the two tracker types share plenty of DNA. But it’s worth knowing what separates them – just as you’d prepare differently for a tea party of chimpanzees compared to a visit from Auntie Hilda, even though they’re 99% genetically alike.

What are the major differences between ETFs and index funds?

ETFs Index funds
Trading Whenever the stock exchange is open Once a day
Pricing Fluctuates all day One price daily but unknown when you trade
Order types Usual range from your broker n/a
Minimum investment Typically one share Typically £25 to £100
Broker FX fees Avoid with GBP priced ETFs Not a problem
Investor compensation Not covered by UK compensation scheme Compensation applies to UK domiciled funds
Choice Access exotic markets Limited to broad markets

The main differences that are relevant to your ETFs vs index funds decision. 

We’ll now look at each difference in more detail below. 

ETFs vs index funds: trading

The big difference between ETFs and index funds lies in how they’re bought and sold. 

ETFs trade on a stock exchange, just like ordinary shares in single companies. In the UK, that means ETFs are listed on the London Stock Exchange.

ETFs can typically be traded any time the stock exchange is open. You could buy an ETF over breakfast and then sell it before you’ve finished the washing up. 

Index funds are bought directly from the financial services provider who runs the fund – albeit most often via a third-party platform such as Hargreaves Lansdown [3] or Interactive Investor [4], who acts as an intermediary.

Funds are only traded once a day, often at midday. 

Fund providers set a daily cut-off point for trades. If you miss that day’s dealing deadline then your trade goes through on the following working day. 

11am is a common cut-off point but it varies from fund to fund. 

Either way, your ETF or index fund transactions are routed through an investing platform. (Some large providers like Vanguard enable you to buy and hold both directly with them. They are effectively their own broker.)

The difference is whereas you’ll know the outcome of your ETF trade in seconds – and you can immediately reinvest the proceeds of a sale – you’ll often wait a day or two to find out what happened with your index fund. And if you sold, it’ll take that day or two before you can put the proceeds of your index fund sale to work. 

ETFs can be traded using stop-loss, limit, and market orders. Index funds don’t have these options. 

Limit orders can be useful in enabling you to set a maximum buying price and minimum selling price, and then leaving the broker to execute your trade for you.

ETFs vs index funds: pricing

ETF prices fluctuate all day – although your broker will quote you a price per share before you trade. 

ETFs also have two prices at any given moment: a buying price (bid) and a selling price (offer). This is known as the bid-offer spread [5].

This spread means you’ll pay more to buy into an Exchange Traded fund than you will get for selling it a second later. It’s just like when you buy foreign currency for a trip abroad.

This is a cost of trading because you’re instantly down at the moment you’ve bought your shares.

True, the spread is negligible on ETFs with plenty of buyers and sellers. Such ETFs cover broad, deep markets such as the MSCI World or FTSE 100. 

However on a small and illiquid ETF, the spread can be over 1%.

Hargreaves Lansdown shows an ‘indicative spread’ estimate in the cost section of its web page for each individual ETF. 

You can also calculate the bid-offer spread from the prices given on the ETF’s homepage, via the London Stock Exchange [6], or through your broker.

Index funds are priced once daily at a specific valuation point. A fund’s price reflects the underlying value of its assets or net asset value [7] (NAV).

Bizarrely, you don’t know what price you will buy or sell a fund for. 

You know the fund price at its last valuation point. But your trade will execute at the next valuation point. 

Effectively you’re trading half-blind. One consolation though is that statistically you’ve got about the same chance of gaining a better price as a worse one when your deal goes through.

Most index funds offer a single price. There’s no bid-offer spread to think about. 

However, the spread still exists. It’s just concealed in other charges.

ETFs vs index funds: minimum investment

ETFs are typically available from UK brokers in lots of at least one share. Aside from that, most brokers don’t impose a minimum investment amount.

A few brokers allow you to trade a fraction of a share. This is called fractional ETF investing and is handy if the ETF’s share price is higher than the sum you have to invest. InvestEngine [8] offers fractional ETF investing. 

Index fund shares are called units. You can always trade fractions of a unit. For example, you can buy a half or even 0.333 of a unit. 

However, brokers often require you to invest a minimum amount in funds – from £25 to £100. The minimum is usually lower for monthly investment plans. 

Disregard any minimums that suggest you must invest thousands into a fund. Those thresholds apply to institutional brokers who buy directly from fund providers instead of via a broker. But the literature is not always clear on this.

Index funds vs ETFs: fees

There aren’t any significant ETF vs index fund differences when it comes to fees. There are though some banana skins to tap dance around.

Ongoing Fund Charges (OCF) – sometimes ETFs are cheaper than index funds in certain sub-asset classes. Other times index funds win. 

Monevator keeps a beady eye on low-cost index funds [9] and ETFs.  

Trading fees – there are zero-commission options for funds and ETFs. See our broker comparison [10] table. 

Platform fees – index funds and ETFs are generally treated the same by flat-fee brokers. 

Percentage-fee brokers tend to become more expensive for funds at a certain point. When they do you’re better off switching to a flat-fee broker, or only using ETFs via a broker who caps its fees. 

Fully optimising investment fees is a complex area but the upshot is that beginners will often find index funds are cheaper than ETFs until they reach the £20,000 threshold in an ISA and more than £60,000 in a SIPP. That’s true so long as your broker offers zero-commission fund trades. 

FX fees – some ETFs incur foreign currency conversion costs from your broker. Whereas vanishingly few index funds fall into the same punji pit. 

You’re fine if your fund’s webpage or factsheet says its base currency is GBP. Check your ETF’s base currency and trading currency is GBP to avoid additional FX fees [11].

ETF vs mutual fund vs index fund

ETFs, mutual funds, and index funds are all types of open-ended collective investment fund. 

But what’s an open-ended fund?

Well, it’s a collective investment vehicle that can create new fund shares (or units) to meet demand from buyers. It can also cancel shares to satisfy sellers. This mechanism ensures that a fund’s value rises and falls in line with the assets it holds (known as its Net Asset Value (NAV)).

Common open-ended fund legal structures include: Open-Ended Investment Companies (OEICs), Unit Trusts, and ETFs.

The alternative approach is a closed-end product such as an Investment Trust [12].

A closed-end fund restricts the number of shares available in the fund itself. It doesn’t add or subtract new shares as money flows into and out of the fund – rather the price changes with supply and demand. The upshot is that the price of a closed-ended fund can include a substantial premium or discount on top of its NAV. That creates a whole new dimension of risk and complexity that most passive investors can do without.

Index funds in the UK are commonly set up as OEICs. Some are structured as Unit Trusts, some as Investment Companies with Variable Capital (ICVCs).

The practical difference between these types is negligible from an investor’s perspective, except that Unit Trusts have a bid-offer spread. 

Mutual funds are the US equivalent of OEICs. But the term ‘mutual fund’ has crept into the UK investing lexicon as a collective noun for our minefield of open-ended fund types. 

You may also stumble across European equivalents such as SICAVs (société d’investissement à capital variable) and FCPs (fonds commun de placement).

If you’re ever in doubt as to the suitability of a fund, look out for the acronym UCITS in its name, or on its homepage or factsheet. 

The Undertakings for the Collective Investment in Transferable Securities (UCITS) directive is a European regulatory standard. It helps regulate funds that are deemed suitable for use by everyday investors1 [13] across Europe including the UK.  

ETFs vs OEICs 

Effectively this entire article is about ETFs vs OEICs because most index funds are classed as Open-Ended Investment Companies. 

However, actively managed funds are structured as OEICs, ICVCs, and Unit Trusts, too. 

Active funds are not bound to track an index. They can follow whatever strategy their manager thinks best. This freedom to pick stocks and time the markets imposes higher costs on active funds. Such fees undermine active funds [14] performance on aggregate, making index trackers the better bet. 

A curious problem for index funds is that they can be hard to find among the long lists of active funds maintained by brokers or your workplace pension scheme. 

The best way to find index funds is to:

Only a few fund providers actually carry a decent number of index funds in their range. We name the main players to search for in the next section. 

Beware too that there are a handful of ETFs on the market that use active management strategies. They’re few in number though and should be clearly labelled. You’ll probably spot them because they’ll sport an unusually high OCF for an Exchange Traded Fund.

Is an ETF an index fund? 

Technically an ETF is an index fund because it is an investment fund that tracks an index. However, the term ‘index fund’ is more commonly used to distinguish index-tracking OEICs, Unit Trusts, and ICVCs from Exchange Traded Funds.

Note, that neither active ETFs nor active funds can be described as index funds because they are not bound to follow a recognised index.

​​ETFs vs index funds: choice

ETFs vastly outnumber index funds. If you want to invest in a niche sector or theme [15] then you’ll likely find an ETF to fit the bill. 

The following brands offer an extensive range of ETF options for UK investors:

Index funds are fewer in number but still provide plenty of choice. Especially if you want exposure to big, diverse markets via global trackers [16] and bond funds [17], among other asset classes. 

The index fund market leaders are:

Most brokers offer both types of tracker but you’ll find the occasional platform that restricts you exclusively to funds or ETFs.  

Our low-cost index funds [9] and ETFs page offers a useful snapshot of the tracker market, divided by sub-asset classes.

ETF vs index fund UK

If you’re searching for ETF vs index fund UK info you’ll probably uncover plenty of US articles discussing pros and cons that just don’t apply over here. 

Here’s a quick list of the areas where there’s no significant difference between ETFs and index funds in the UK:

Stock-lending [19] is a common practice that is product agnostic. ETFs, index funds, active funds, investment trusts and even your broker can lend out your securities to third-parties. 

It all depends on the policy of the product provider. Not everyone does it and you can choose ETFs or index funds from providers who don’t if you want to. 

A fund or ETF provider will state on its website which products are not subject to securities lending. 

The important thing is that companies are transparent about their lending policy and share the proceeds with investors who bear the counterparty risk [20].

Are index funds safer than ETFs?

Index funds are not safer than ETFs. Your capital is at risk in both tracker types, just as it is in any investment. 

However, ETFs are riskier than index funds in the sense that they’re not covered by the UK investor compensation scheme [21] whereas some index funds are. 

In short, if your product provider is a UK authorised firm (as defined by the FCA) then its UK-domiciled funds are eligible for compensation. 

However, funds domiciled overseas are highly unlikely to be eligible. All ETFs are domiciled abroad hence you’d find yourself whistling should compensation ever be needed. 

Thankfully the scheme hasn’t ever been called upon to bail out owners of a major fund provider. Moreover, the payout terms are quite narrow. The most you’d ever receive is £85,000 per insolvent firm. 

But many people don’t realise that overseas funds and ETFs aren’t covered by the UK scheme.

You can check your index fund or ETF domicile on its homepage or factsheet. 

Riskier ETF types

There are a range of exotic ETFs that are fundamentally riskier than vanilla index funds because they behave in unexpected ways that require considerable expertise to understand. 

To play safe, run don’t walk from:

Other Exchange Traded Products (ETPs) that are related to ETFs but entail greater risk include:

Exotic ETPs can be expensive, harbour hidden risks, and often owe more to financial fashion than financial sense. Don’t venture down the back alleyways unless you know what you’re doing. And even then think twice.

Synthetic ETFs

ETFs divide into two main types:

Physical ETFs hold the securities tracked by their index as you’d expect. They either replicate the index in full or sample a significant proportion. So far, so normal.

Synthetic ETFs, in contrast, do not own the securities in their index. Instead they buy an instrument known as a ‘total return swap‘ from a financial institution, such as a major investment bank.

This total return swap pays out the return of the index tracked by the synthetic ETF. The ETF pays that return to its investors (minus costs) while the financial institution gets the ETF’s cash as well as any return from the collateral the ETF manager has set aside.

If you’re currently shouting: “What witchcraft is this?” I wouldn’t blame you – they are weird.

Synthetic ETFs are exposed to counterparty risk – in other words, they could lose money – if the swap provider defaults on its obligation to pay the return of the index.

In this instance, the ETF would use its collateral to pay investors back the value of their holdings. However, there is no guarantee that the collateral would fully cover investors if a swap provider defaults during a market meltdown.

You can avoid counterparty risk by choosing ETFs or index funds that physically replicate their index and that don’t lend out their holdings.

The ETF’s homepage should say whether the ETF is synthetic or physical. Email its provider if you can’t find what you’re looking for.

Index funds physically replicate their index. They don’t exist in synthetic form.

Index funds vs ETFs for beginners

Index funds are more suitable for beginners than ETFs because they’re the most straightforward tracker type. They should be your first choice where possible.

ETFs are a slightly more complicated product. However there are plenty of plain, vanilla ETFs that are just fine for beginners. 

Ultimately, you won’t go far wrong if you stick to straightforward ETFs that track familiar markets like the developed world, the UK, government bonds, and the emerging markets.

In your hunt you’ll also likely dig up highly specialised ETFs (and related animals) that offer exposure to niche markets.

Steer clear of those unless you’re absolutely sure you understand the risks. 

ETF or index fund?

Neither ETFs or index funds are better. They’re both excellent building blocks for your portfolio, and you should feel free to pick the investment that best fits your plan. 

Ultimately, the ‘ETFs vs index funds’ match-up is a score draw. Index funds are marginally simpler to understand and use but ETFs are unmatched for choice and diversity.

Passive investors should feel free to mix and match the two types for the best of both worlds.

Take it steady,

The Accumulator

Note: We kept older reader comments intact when we completely rewrote this article in 2022. Some aspects of the ETFs vs index funds debate have changed over time, so please keep that in mind.

  1. Or retail investors as we’re known in the finance industry. [↩ [30]]