What's the Difference Between Index Funds and ETFs

People use the terms index fund and ETF (exchange traded fund) interchangeably, but did you know they actually mean two different things?

Here’s a quick guide to help you figure out the difference - and which one suits your investment strategy.

An index fund is a fund that tracks a list of companies known as an index.

An index is usually designed to measure the performance of a certain market or sector. The S&P/ NZX 20, for example, is an index that tracks the 20 largest companies on the New Zealand sharemarket. An index fund, such as the Kernel NZ 20, simply holds those same companies in the same proportions, so its performance closely mirrors the index.

Following an index is what's known as a "passive" approach. Instead of a team of analysts trying to pick winners, the fund simply mirrors the market - and that hands-off approach is why index funds can generally charge lower fees than actively managed funds.

ETF stands for Exchange Traded Fund. The clue is in the name: it's a fund whose units are listed and traded on a sharemarket, like the NZX or NASDAQ, the same way you'd buy and sell shares in a company.

So in other words, the term "ETF" is actually about how you access the fund - on-market, at a live price.

• Most ETFs are index funds. The bulk of ETFs on the market track an index, like the Vanguard S&P 500 ETF, which is how they earned a reputation as a "passive" product.
• But not all index funds are ETFs. Plenty of index funds aren't listed on any exchange. You buy them directly from the fund manager (or through a platform) instead. This is how Kernel’s funds work.
• And not all ETFs are index funds. A small number of ETFs are actively managed - they trade on the exchange but still have a manager picking the holdings.

The choice most New Zealand investors are actually weighing up is an unlisted index fund (bought directly from a provider like Kernel) versus an index-tracking listed ETF. Same passive strategy, different wrapper.

This isn’t the most exciting part - but it’s worth slowing down for, because tax can greatly affect your investment returns.

• ETFs listed on the NZX are classed as listed PIEs, taxed at a flat 28%.
• ETFs listed overseas can be taxed under the Foreign Investment Fund (FIF) regime if the cost of your overseas holdings exceeds $100,000.
• Most unlisted New Zealand index funds are multi-rate PIEs, taxed at your Prescribed Investor Rate (PIR) and capped at 28%.

If your PIR is below 28%, an unlisted multi-rate PIE can be more tax-efficient than a listed ETF holding the same companies, as you’ll be taxed at your lower PIR rate. And ETFs based overseas can also pull you into the FIF rules, which usually means more paperwork at tax time (and maybe a little extra tax too).

None of this is tax advice, and we don’t know your specific situation. Before investing we recommend doing your own homework on tax efficiency to figure out what’s best for you.

Read more about how tax works with Kernel funds

An unlisted index fund might suit you if you’re building the core of your portfolio and want tax-efficient, low-fee investments that you can set and forget. You don’t care about trading through the day, and you’re looking for a simple option you can set up for automatic investment.

• Can be one of the lowest-cost investments available
• Designed to be tax-efficient for most NZ investors
• Instant diversification
• Tax is handled by the fund manager and automatically reported and paid to Inland Revenue

• May not offer as many choices as ETFs
• Orders are not processed instantly but batched and accepted at a set cutoff (for Kernel that’s just after 12 pm business days). Some investors may find that it feels ‘slower’ compared to ETFs

View Kernel unlisted index funds

An ETF tends to suit you if you want to buy and sell on-market at a live price, and you want access to a specific ETF that isn’t offered in an unlisted form. ETFs are a great way to access more niche overseas-based sectors and trends.

• Instant diversification, similar to unlisted funds
• Greater access to individual countries, themes and sectors (eg, India, Water, or Technology)
• Flexibility of trading, you can buy and sell while the markets are open at a price you choose

• Trading costs for buying and for selling, including brokerage, foreign exchange, and platform fees.
• The range of options can be daunting for those new to investing
• Potential for over-diversification, as some investors may hold too many overlapping ETFs
• Tax compliance can be complex and administratively burdensome, especially for overseas shares, due to New Zealand's FIF rules

View Kernel shares and ETFs

The fact is, a mixture of both can be used to create a diversified portfolio. The key to getting the mix right is following a well-thought-out investment strategy (such as core-satellite) and thinking about your investment horizon, tax treatment, and the fees you’re getting charged.

Want the wider picture on how ETFs stack up against direct shares and unlisted managed funds? Read ETFs vs Shares vs Unlisted Funds.

Kernel Wealth Limited is the manager and issuer of the Kernel KiwiSaver Plan and Kernel Funds Scheme. A Product Disclosure Statement is available at Kernel Wealth | Resources & Documents. Investing involves risk including the possible loss of principal and there is no assurance that the investment will provide positive performance over any period of time. The information provided should not be relied upon as investment advice or recommendations and should not be considered specific legal, investment or tax advice.