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In the near future, I plan to buy some low-cost tracker funds for my Stocks and Shares ISA. These can sit alongside my individual stock holdings.
The question is – should I go for index funds or exchange-traded funds (ETFs)? Let’s discuss.
What’s the difference?
Index funds and ETFs are two different types of tracker funds. They are similar in nature in that they track indexes such as the FTSE 100 and the S&P 500 for a low cost. However, there are key differences between the two types of products.
The main difference is that ETFs trade on the stock market while index funds don’t.
So, for example, while the Vanguard S&P 500 UCITS ETF trades on the stock market (under ticker VUSA), the Vanguard US Equity Index fund isn’t listed.
Index fund pros and cons
Now, both index funds and ETFs have their pros and cons.
The big advantage of index funds, to my mind, is that there are generally no trading commissions to invest in them.
This means they can be quite cost effective if a) only small amounts are invested or b) making just small regular contributions.
For example, if I wanted to just invest £200 or £500 here and there in a tracker fund, they might be more cost efficient.
On the downside, investors generally have to pay higher annual platform charges compared to owning ETFs.
For example, Hargreaves Lansdown currently charges an annual fee of 0.45% a year (capped at £45) on portfolios that own shares (ETFs are counted as shares).
However, for portfolios that own funds, the fees are 0.45% for the first £250k, 0.25% on the value between £250k and £1m, and 0.1% on the value between £1m and £2m (no fees after £2m).
So £100,000 in an ETF is only going to cost me £45 a year in annual fees while £100,000 in an index fund is going to cost me £450. That’s a big difference.
Another drawback of index funds is that they can only be bought at end-of-day prices (more on this below).
ETF advantages and disadvantages
Turning to ETFs, the big advantage of these products is that they allow you to be a lot more nimble when investing because they can be bought and sold at intraday prices. This can be really handy during periods of market volatility.
For example, the S&P 500 recently had a huge intraday swing in which it fell around 1% at the start of the day and then surged to finish the day up more than 1%.
If I’d been on my toes, I could have potentially bought in at the low point of the day with an ETF and ended the day up around 2%.
I couldn’t have done this with an index fund however, as if I’d hit the buy button at the time, I would have received the end-of-day price.
The other big advantage is that annual platform fees tend to be a lot lower as I mentioned earlier.
On the downside, most platforms charge trading commissions to buy ETFs. If I was looking to put money into a fund regularly, these could add up.
My choice
Weighing up the pros and cons of each, I feel that ETFs are a better fit for me.
They may have trading fees. However, they will allow me to make intraday trades and should also reduce my overall fees over the long term.