1. Exchange-Traded Funds: Introduction
  2. Exchange-Traded Funds: Background
  3. Exchange-Traded Funds: Features
  4. Exchange-Traded Funds: Biggest ETFs and ETF Providers
  5. Exchange-Traded Funds: Active Vs. Passive Investing
  6. Exchange-Traded Funds: Index Funds Vs. ETFs
  7. Exchange-Traded Funds: Equity ETFs
  8. Exchange-Traded Funds: Fixed-Income and Asset-Allocation ETFs
  9. Exchange-Traded Funds: ETF Alternative Investments
  10. Exchange-Traded Funds: ETF Investment Strategies
  11. Exchange-Traded Funds: Best Practices for Trading ETFs
  12. Exchange-Traded Funds: Conclusion

In this section, we evaluate index funds versus ETFs to evaluate the optimal way to implement a passive investing strategy. 

Investment choice

ETFs are more versatile than index funds because they can be designed to track almost any index or asset class, thus offering more investment choices for the investor. Index funds are more restricted in terms of investment choices available. (Related: What's the difference between an index fund and an ETF?)


ETFs can be short sold, while inverse ETFs and currency ETFs can be used for hedging market and currency risk. Their flexible nature makes them suitable for being used in a variety of investment strategies.


While investors can buy or sell index funds without incurring any transaction costs, they have to pay brokerage commissions when trading ETFs. On the other hand, while index funds incur costs due to constant rebalancing on account of daily net redemptions, ETFs avoid these transaction costs because of their unique in-kind creation / redemption feature. 


Index funds have the edge here, because they can reinvest their dividends immediately. However, ETFs have to accumulate dividends or interest received from the underlying securities until a distribution can be made to shareholders at the end of the quarter. (Related: ETFs Vs. Index Funds: Quantifying The Differences)


Index funds trigger capital gains when they sell securities. With ETFs, the in-kind creation / redemption feature eliminates the need to sell securities. ETFs also avoid capital gains by transferring the out the securities with the highest unrealized gains as part of the redemption in-kind process.  


Rebalancing an ETF portfolio may result in multiple brokerage commissions having to be paid for buying and selling the ETFs. Rebalancing an index fund portfolio may not result in any transaction costs. Fine-tuning the portfolio is also easier with index funds because fractional fund shares can be traded.

Dollar-Cost Averaging

Dollar-cost averaging is better carried out with mutual funds than with ETFs, because of the brokerage commissions that have to be paid when trading ETFs.


Mutual fund investors are always assured of getting the end-of-day NAV. However, ETF investors may have to contend with a significant difference between the market price of an ETF and its NAV during bouts of volatility or when liquidity is constrained, resulting in a wider bid-ask spread that adds to the cost of trading ETFs.





Exchange-Traded Funds: Equity ETFs
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