ETFs Vs Index Funds – A mutual fund is a basket of stocks, bonds or other types of assets which is professionally managed by an investment company. For managing resources, the fund charges a fee. Holdings are selected by portfolio managers who pick stocks poised to perform the best and leave the rest. But if active management is not your cup of tea, index funds could be the right choice. Is the distinction between Exchange Traded Funds and Index Mutual Funds a mere storm in a teacup? Or are these two types of funds poles apart? Let us explore the fascinating world of index funds and find out.
The article on ETFs Vs Index Funds is structured as below –
- Index Fund: Chasing the Market
- Exchange Traded Funds: The Traditional Route
- ETFs Vs Index Funds: The Trade Off For Investing
- The Cost Factor: Where Exchange Traded Funds Score over Index MF
- Mutual Fund or Index ETF? The Many Differences
- Conclusion- ETFs vs Index Funds
Index Fund: Chasing the Market
An index fund has a very different strategy from the traditional method of operating a mutual fund. Rather than picking and choosing stocks in a lookout to beat the market, an index fund purchases all shares making up an index to replicate the performance of an complete market. So, why would anyone want to settle for average returns when they can ride the storm and come out winners in the trading game? Quite simply because index funds are cheap to operate and they buy and hold rather than trading frequently- a strategy which suits many people. Research shows that higher expenditure linked to actively managed mutual funds make index funds an attractive idea. Winning stocks may beat the market, but index funds provide stable returns- something which is increasingly important if you don’t want to test waters, but sail smoothly on. Studies also show that active funds do not deliver good returns compared to index funds. S&P Dow Jones has found in a study that over a period of 10 years, lower than 20 percent of actively managed funds beat the S&P 500 index!
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Exchange Traded Funds: The Traditional Route
There are two types of index funds- ETFs or exchange traded funds and index mutual funds. With a MF, buyers and sellers undertake transactions directly with the fund company. ETFs are not sold by fund firms and are listed on the exchange (hence the name) and buyers or sellers of shares must own brokerage accounts to trade in these.
The best things in life are not free if you’re investing in Exchange Traded Funds because you pay a brokerage commission whenever you make a purchase or sale. For small investors, traditional index mutual funds work out to be less costly therefore. But for every risk in the markets, there is a reward and this holds true for ETFs as well. As they are exchange traded, such shares can be traded at any hour of the day. This is why ETF shares are popular among investors. Exchange Traded Funds has been one of the most rapidly growing segment of the funds business. ETFs trade like stocks and offer flexibility not available in case of traditional mutual funds. Investors can trade ETFs throughout the day as against traditional index mutual funds where investors can only purchase units at the NAV or Net Asset Value of the fund published each time towards the end of the trading day. Exchange Traded Funds are quickly tradable and this offers an undeniable advantage- risk of price differential between time of trade and that of investment is much lower in case of ETFs. ETFs also have lower tracking error than traditional index funds on account of in kind or creation and redemption facility and lower expense ratio. Long term investors can avoid suffering on account of short term investor activity.
ETFs Vs Index Funds: The Trade Off For Investing
Index investors are not necessarily partial to Exchange Traded Funds as an investment vehicle. This is because index funds place retail index investors on the road to success. Moreover, ETFs have been around since the 1990s while the first index MF was introduced in 1970s. So why do ETFs still prevail in the clash of the trading Titans? Primarily because this type of fund offers serious advantages from the point of view of cost, size and time horizon perspective.
Exchange Traded Funds are flexible investment vehicles and appeal to a wide segment of investors, whether their trading strategy is passive or active. Passive institutional investors prefer ETFs for their flexibility. Active traders prefer it for their convenience. In contrast to this, passive retail investors choose index funds for their simplicity.
Another point of distinction is that ETFs can be purchased in smaller sizes and do not require any kind of special documentation or accounts. They are also associated with no rollover costs or margin. ETFs also have a wider scope of coverage in that they cover benchmarks where no futures contracts exist. Active hedge fund traders also prefer ETFs over index because they are exempt from short sale uptick rule applicable for regular stocks.
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The Cost Factor: Where Exchange Traded Funds Score over Index MF
Exchange Traded Funds and index funds have their own particular costs and payoffs, when it comes to expenses associated with index tracking and trading. Costs incurred in tracking index fall into three basic categories:
- Daily net redemptions
- Cash Drag
- Dividend Policy
Daily net redemptions: The Balancing Act
These redemptions result in explicit costs in the form of commissions and implicit costs for bid ask spreads on fund trades, with respect to index funds. Exchange Traded Funds eliminate the need for this balancing act through a process called creation/redemption in kind. Decoded, this means ETF shares can be created and redeemed with a basket of similar securities.
Cash drag refers to cost of holding cash to trade for handling potential daily net redemptions for index funds. ETFs do not incur this cash drag because of their unique redemption process.
Dividend policy is the only cost factor where index funds prevail over Exchange Traded Funds Index funds will invest dividends at once, while ETF shares require cash accumulation during the quarter and their consequent distribution to shareholders with respect to dividend policy.
Non-tracking costs include taxation, shareholder transaction costs and management fees. Management fees are lower for ETFs as this fund does not engage in accounting- this is not so for index funds. Shareholder transaction costs are zero for index funds, on the other hand, unlike ETFs. Taxation of investment vehicles Exchange Traded Funds and index fund favours the former over the latter. Tax events are triggered by the need to sell securities in case of index mutual funds. Capital gains inherent in other funds is also not a feature of ETFs.
Index Funds: Precursors to Exchange Traded Funds
While index funds have been available since 1975, Exchange Traded Funds were traded in 1993 first ETFs cover as many as 5 times the indexes.
Lack of Liquidity: A Drawback for Exchange Traded Funds
Lack of liquidity in case of some Exchange Traded Funds result in increase in bid ask spread, adding to the cost of trading. ETFs which are less popular are not able to have the same arbitrage interest of other ETFs. This creates a massive difference between market prices and net asset values.
Active or Passive: The Alpha and Beta of Investment
While active investors aim for alpha or the best in the market, passive investors level arbitrage to achieve beta or moderate market returns. There are only two possibilities for passive investors namely Exchange Traded Funds and mutual funds. Both track underlying index. Tracking error is the degree to which funds fall short of replicating the index.
Two Degrees of Passive Investment: Angles on ETF Versus Index Funds
Passive investors:
These type of investors aim to achieve asset allocation best suited to objectives at low cost with little activity. Index mutual fund is the best option for such investors. Rebalancing will maintain consistency and ensure adjustment in exposure..
Not so Passive investors:
Exchange Traded Funds are more suitable for this kind of investor. It ensures changes in the portfolio with higher precision and speed. ETF permits users to take a directional view of the market, something which open ended funds cannot hope to match.
Investors may also short sell the ETF if they are passive yet inclined opportunistically. Using Exchange Traded Funds is an active method of a passive investment strategy. Investors should comprehend market dynamics to make a successful investment, whether they chose etfs vs index funds.
Mutual Fund or Index ETF? The Many Differences
Mutual funds have different share classes, holding period requirements and arrangements for sales charge. The aim of the game is to discourage rapid trading. Exchange Traded Funds are build for speed. This is the prime difference between etfs vs index funds. Individual investors need to do their homework to get good grades in the financial market and choose the right index product to make their mark.
ETFs have more volatile prices than index mutual funds. Tax efficiency is a factor on which Exchange Traded Funds and index mutual funds function equally well. When it comes to price fluctuations, index ETF prices vary through the trading day. While both mutual index funds and ETFs share certain similarities, the differences are many. Investors looking to hold investments for long term and have a moderate appetite for risk would be more suited to index mutual funds while investors with more risk taking ability who want short to medium term returns on their plate should choose ETFs. While ETFs Vs Index Funds can be used to own the market at a very reasonable rates, this is where the similarity ends. Here are the brownie points you will score for a bigger risk appetite through Exchange Traded Funds.
Zero Commissions
If you purchase an index fund run by a brokerage, the fee might be waived off, but if the fund in a specific account is used, get ready to fork out money for a low risk appetite. Exchange Traded Funds are commission free or cost very little per trade.
More Liquidity
Index funds are mutual funds so whether you purchase or sell them, getting a pricing at the end of the day. This price would not be unlike what is to be expected. If you’re juggling asset classes however, you could strike out. Liquidity is higher in Exchange Traded Funds making it easy to track common indices as well.
Less Cost, More Gains
Price war has escalated between ETF providers, while peace prevails among index fund providers. ETF are cheaper to own as per expense ratios which are more reasonably pegged.
More Asset Classes
Exchange Traded Funds are also perfect for those who want to be invested in numerous asset classes quite reasonably. Index funds limit the scope to mid cap, speciality and real estate funds. The flexibility offered by ETF means more choices.
Cash Flows That Work For You
If you purchase index funds, the hassle of deciding what to do about incoming dividends may be avoided given the reinvestment. However, short to medium term investors may prefer ETFs because there is control over where the incoming dividends get reinvested, more so in a commission free manner.
Conclusion- ETFs vs Index Funds
The question is a weighty one, but the burden of its implications make it important. Choosing the right investment strategy involves being proactive. After all, as Warren Buffet remarked, you don’t test the depth of the river with both feet! Financial markets are as unpredictable as possible, even if you are following stock market indices. With respect to your appetite for risk, you can formulate the perfect recipe for investment that will score on all counts. The important point here is to choose an investment vehicle which matches your financial roadmap and investing strategies.
Based on resources and preferences of active versus passive funds, you can easily decide whether ETF vs index mutual funds are superior. Though both are passive funds, the fact is that ETFs are more actively passive than their index counterparts. The thumb rule is that if you buy what you don’t need, pretty soon you will be selling things you need. So, opt for an investment vehicle that steers you in the right direction. Individual preferences are based on circumstances and financial resources. Making profits is based on making the right choices. Choose well and you will get excellent returns. This is the essence of examining the trade off between ETFs vs Index Funds, while driving growth through these investment vehicles.
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