Exchange-traded funds (ETFs) and index mutual funds are two of the most popular investment options for passive investors.
They offer broad market exposure, low fees, and the potential for long-term growth (i.e. all the things you want for your retirement).
But which one is right for you? This guide breaks down the key differences, advantages, and drawbacks of ETFs and index funds to help you make an informed decision.
Index investing: The basics
Before diving into the differences, it's important to understand what ETFs and index mutual funds have in common.
Both are passive investment strategies that aim to track a specific market index, like the S&P 500 or TSX Composite, rather than attempting to beat the market.
Passive investing has been proven to outperform actively managed strategies over the long term. By simply mirroring an index and minimizing costs, both ETFs and index funds offer an efficient way to build wealth with less risk than stock-picking.
Tax efficiency is another shared characteristic, though there are differences in how they are structured. In Canada, ETFs and mutual funds are treated similarly when it comes to capital gains taxes and withholding tax on foreign dividends.
Key differences between ETFs and index funds
ETFs | Index funds |
---|---|
Trading: Traded on stock exchanges throughout the day, like individual stocks | Trading: Bought and sold through a mutual fund provider at the end of the day |
Costs: Typically lower management fees (MERs) but may include brokerage fees | Costs: No transaction fees, but often higher MERs |
Minimum investment: Can buy as little as one share; some brokers offer fractional shares | Minimum investment: Often require a minimum initial investment (e.g., $500 - $1,000) |
Tax efficiency: More tax-efficient due to in-kind creation/redemption process | Tax efficiency: May generate capital gains distributions, triggering taxable events |
Flexibility: Can use limit orders, stop-losses, and margin trading | Flexibility: Less flexibility; trades are executed only once per day |
Best for: Investors looking for low fees and flexibility | Best for: Investors making small, frequent contributions |
Real life comparisons of an Index ETF vs a Index mutual fund
Let's look at two of the most popular indices and the fund that track them.
Index mutual fund | Index ETF |
---|---|
TD U.S. Index Fund – e-Series (TDB902) | iShares Core S&P 500 ETF (IVV) |
MER: 0.28% | MER: 0.03% |
Buy with TD Easy Trade | Buy with Wealthsimple |
Index mutual fund | Index ETF |
---|---|
RBC Canadian Index Fund (RBF556) | iShares S&P/TSX 60 Index ETF (XIU) |
MER: 0.66% | MER: 0.18% |
Buy this mutual fund with RBC Direct Investing | Buy with Wealthsimple |
The difference fees make in your portfolio
Don't be a Sam, be a Raquel.
Advantages of ETFs over index funds and the downsides of ETFs
Pros
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Lower fees. ETFs generally have lower expense ratios than index mutual funds. For example, Vanguard’s Canada All Cap Index ETF (VCN) charges just 0.06% in MER. Lower fees mean more of your money stays invested and compounds over time.
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More investment choices. ETFs offer access to a wide variety of sectors and investment styles, from broad market indices to niche categories like technology, dividends, or REITs.
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Greater flexibility. Since ETFs trade like stocks, investors can buy or sell them at any point during the trading day, use limit orders, and even short sell or trade on margin.
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All-in-one portfolio solutions. All-in-one ETFs, like asset allocation ETFs from Vanguard, iShares, and BMO, provide a globally diversified portfolio in a single fund with an MER as low as 0.18%–0.25%.
Cons
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Brokerage fees. Many brokerages charge trading fees for buying and selling ETFs, making them less ideal for small, frequent contributions.
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Market fluctuations. Because ETFs trade throughout the day, their prices fluctuate, which can lead to emotional decision-making for inexperienced investors.
Advantages of index funds over ETFs and the downsides of index funds
Pros
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No trading fees. Most index mutual funds can be purchased without commissions, making them ideal for investors who contribute small amounts regularly.
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Easy automation. Investors can set up automatic contributions to buy index funds on a regular schedule, making it a great tool for dollar-cost averaging.
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Simplicity. No need to worry about bid-ask spreads or placing market orders—index fund purchases are straightforward and executed at the day’s closing price.
Cons
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Higher MERs. While still cheaper than actively managed funds, index mutual funds generally have higher MERs than ETFs.
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Limited selection. The Canadian market offers fewer index mutual funds compared to the growing variety of ETFs.
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Less control. Investors can only buy and sell at the end of the trading day, limiting flexibility in volatile markets.
ETF vs. index fund: Which one is right for you?
Here's some simple rules of thumb:
- If you're investing small amounts frequently (e.g., biweekly contributions to your RRSP or TFSA), index mutual funds may be the better choice since they come with no trading fees.
- If you have a larger portfolio ($25,000+), want lower costs, and prefer more control, ETFs are the smarter option.
Looking for a hands off approach?
Then you should consider robo-advisors like Wealthsimple, Moka or Questwealth, which build and manage diversified ETF portfolios for you.
Final thoughts
Both ETFs and index funds offer low-cost, diversified exposure to the stock market, making them excellent choices for long-term investors. The best choice depends on your investing style, contribution frequency, and cost sensitivity.
If you’re ready to start investing, choose a commission-free brokerage or a robo-advisor to simplify the process. Either way, taking the passive investing route puts you on a solid path toward long-term financial growth.
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Robb Engen is a leading expert in the personal finance realm of Canada and is also the co-founder of Boomer & Echo, an award-winning personal finance blog.
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