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A Noobs Guide On Index Funds & ETF's

Updated: Nov 2, 2021

Index Funds & ETF's are the bread and butter of passive investing. You must understand what they are before investing in them and how they can help you build long term wealth.

In this article I will explain what both are, and how they are different to each other!

What Are Index Funds & ETF's?

An index fund or ETF (exchange traded fund) is a passively managed fund that tracks the performance of a financial market index. Examples of indexes include the FTSE 100 (the top 100 companies in the UK) or the S&P 500 (the top 500 companies in the US).

What this essentially means is, the index fund or ETF mimics the behaviour of the stock market, whether it is falling in value or rising.

Index funds & ETF's provide a broad exposure to a number of different companies and industries, and are extremely cheap for investors to hold. This is because they both have low expense ratios (some as low as 0.03%).

Diversification is crucial for an investor because if one industry gets hit hard by steep declines, you have several others that will help reduce or nullify its effect on your portfolio.

Index funds & ETF's that track the S&P 500 and FTSE 100 are some of the lowest risk investments you can hold. This is because they are broad markets and throughout their history, both have returned positive average annual returns (which basically means since they were created, they have always bounced back stronger from any major dips or crashes).

What Are Their Differences?

Most of the differences are irrelevant to long term investors, however it is useful to know about them.

The most important difference for long term investors is that some index funds require a higher minimum level of investment than ETF's do. So if you're just starting out and don't have thousands to invest then ETF's are the much better option. ETF shares can be bought fractionally so even if you can't afford one share of an ETF, you'll still be able to invest in it!

ETF's can also be bought and sold during the day, whereas index funds are only priced up at the end of the day. This doesn't really matter to long term investors, but for short term investors the liquidity of ETF's is more attractive.

Another difference is the type of fees both ETF's and Index Funds incur. ETF's incur a bid-ask spread, which an Index Fund does not. But this is very minimal if you are buying a high volume, broad market ETF (such as one that tracks the S&P 500 or the FTSE 100).

Some Index Funds come with transaction fees that aren't incurred by ETF's, and both are susceptible to trading commissions from the broker. However, there are plenty of 0% commission brokers out there that you can use to rid yourself of that burden. My personal choice is Trading212!

ETF's are the cheaper option regarding taxation as well, due to their structure. However this is only relevant if you sell your funds and are using a taxable account.

If you do for some strange reason want to find out more about all of that, you can check out this excellent article on NerdWallet.

Whether you're considering buying an Index Fund or ETF, it is worth checking what the costs are before you invest in them. The differences can seem insignificant but compounded over time it can have a big effect on your future returns.

Keep costs low, and your returns will be higher!

Why Index Funds & ETF's Are Fundamental For Your Portfolio

Index Funds & ETF's are not concerned with trying to "beat the market", they are concerned with trying to match it. And since the inception of the FTSE 100 and the S&P 500, their average annual return has been 8% and 10% respectively.

Buying individual stocks can give you bigger returns than that, but the risk is higher. Whereas investing in Index Funds & ETF's your risk level is very low, but your returns in the long-term could still be huge.

Passive investors rely on compound interest to generate huge returns, not on the growth potential of individual stocks, and it is one of the safest strategies to build long term wealth.

This article is not investment advice, and is for informational purposes only. If you are unsure of what type of investment is right for you, please speak to a professional financial or investment advisor.

If you found this article helpful, please consider buying me a coffee on Ko-Fi. All coffees will be reinvested back into the website and I won't add sugar to any of them, this website is sweet enough :P


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