Exchange-traded funds have garnered much of the buzz - and new assets - in the managed funds industry over the past decade.

But at heart, they're not a whole lot different from traditional index funds, which have been around since the late-1990s:

  • Both are investment funds overseen by professional managers
  • Both are managed passively, meaning the portfolio tracks a market index such as the ASX 200
  • Both are relatively low cost when compared to actively managed funds
  • Both offer easy access to a range of global markets and asset classes

However, the design of the two products means investors should be aware of the differences  between them when it comes to trading, dividends and cost.

In the end, the decision about whether to choose a traditional index fund or an ETF boils down to which features the investor values most. And the debate needn’t be an either/or question. You can consider both.

Purchase price: advantage index funds

ETF investors must pay commissions to brokerage firms to buy and sell, whereas most traditional index funds are available on a commission-free basis. This can get costly for investors who want to continuously invest small amounts in ETFs – a proportion of their fortnightly salary, for instance.

ETF investors can also come with other transaction costs. Investors may be confronted with large bid-ask spreads, particularly if they're buying or selling large amounts in ETFs with low liquidity holdings.

Trading costs won't matter much to ETF investors who are trading little and focus on highly liquid ETFs with liquid holdings, but they can be more meaningful to investors who do otherwise.

Management costs: advantage ETFs

Exchange-traded funds are slightly cheaper than traditional index funds for retail investors, as illustrated in the example of Vanguard’s product suite in the table below. However, wholesale index fund investors - those with greater minimum sums to invest – or those who can gain access to the fund via an investment platform - can lock in management fees comparable to ETFs.

Management fee (p.a.) comparison

Table comparing management fees between Vanguard funds

Source: Vanguard

Trading flexibility: advantage ETFs

A key advantage of ETFs is that they can be intraday via the stock market. Traditional index funds can only be bought once a day, after the market is closed and the current value of the securities in the portfolio is toted up.

Investors can also customise their order type with ETFs, using limit orders, stop-loss orders, and stop-limit orders. Buy-and-hold investors have no reason to value these features or the ability to trade intraday, but investors who trade frequently will find that ETFs offer more flexibility.

However, as the late index fund pioneer Jack Bogle warned, the tradability of ETFs can tempt investors to trade frequently, which can foster damaging habits.

Exposure to major market segments: tie/slight advantage ETFs

Investors seeking exposure to a core capitalisation-weighted index – whether it's tracking Australian stocks, foreign stocks, or bonds – will be able to find it in either traditional index fund or ETF form.

However, investors seeking exposure to various sub-asset classes and sectors – for instance, the NASDAQ, a technology ETF, a currency – will be better served by ETFs.

Morningstar associate director, manager research, Alexander Prineas says this advantage can be a curse as it can give investors temptation to pick last year’s hottest performers.
As we know, past performance should never be taken as an indication of future performance.

Minimum investment amount: advantage ETFs

While investors can buy as little as a single share in an ETF, index funds typically stipulate higher initial minimum investment amounts. For example, Vanguard’s retail index funds typically have an initial investment minimum of $5000, while State Street minimums are $25,000.

However, once you're in the fund, the additional minimum investment amount drops.

It’s worth nothing too that some funds, such as Vanguard, require minimum account balances and set minimum withdrawal amounts.

Reinvest dividends and capital gains: advantage index funds

For investors who reinvest their dividends/distributions and capital gains, the process is somewhat easier for traditional index fund investors than it is for ETF investors. The process is as simple as checking a box for index-fund investors.