Updated: Sep 21, 2020
Many investors are interested in buying a company’s business to share in the profits. Do you know you can buy into many companies at one time? These are called Index Funds.
The first index fund was created in 1976, tracking the Standard and Poor’s 500 Index. The S&P500 index comprises of 500 companies listed on the New York Stock Exchange (NYSE) and the NASDAQ Composite, and is considered to be the best representation of the U.S. stock market. Therefore, this fund packages individual stocks in the index into a single investment, and proved to be very popular for investors. Today, there are more than of tens of billions USD in indexed funds.
Exchange-Traded Funds (ETF), created in 1989, are funds holding a portfolio of assets, which could be financial instruments such as securities (stocks and bonds) or commodities. ETFs are similar to index funds, but with the added feature of being traded on the stock exchange. Currently, the ETF market is over 3 Trillion USD and comprises more than 2000 funds. The largest are Equity ETFs (approx. 70%), followed by Fixed Income ETFs (16%) and Commodity ETFs (6%) and some Currency ETFs. Majority of ETFs passively track a market index, such as a stock index or bond index, although there are also small number of actively managed ETFs.
Both Index Funds and ETFs offer investors portfolio diversification. For instance, the S&P500 fund provides exposure to five hundred of the US’ largest companies. Both Index Funds and passively managed ETFs also offer lower costs for investors compared to actively managed mutual funds. For mutual funds or unit trusts, they require dedicated fund managers making active decisions to select which stock or bond to invest and include into the fund, therefore resulting in higher expense ratios. Expense ratios are calculated by dividing a mutual fund’s operating expenses by the average total dollar value of all the assets in the fund. The average expense ratio for actively managed mutual funds ranges between 0.5% - 1.0%. while passive index funds, the typical ratio is about 0.15- 0.2%. Many Index Funds and ETF’s also allow investors to reinvest capital gains and dividends, if applicable. In addition, both Index Funds and ETFs offer steady positive long term returns. Even as these funds track the short term fluctuating ups and downs of the index, these indexes have been proven historically to give positive returns, To illustrate this, the annualized average return for the S&P Index is approx. 9.8% since inception in 1926 and approx.. 7.9% since adoption of 500 stocks in 1957.
So would you rather invest or trade in an Index Fund or a ETF? Let us consider…
ETFs are being traded throughout the day just like equity in a stock exchange, while Index Funds can be transacted only for the price set at the end of the trading day. This is not a real issue for long term investors. Shorter term traders, on the other hand, will prefer the ETF over Index Funds. ETFs give investors the option to transact through the day, which may promote impulsive buying or selling behaviour. Therefore, it is prudent to follow your pre-specified investing plan, no matter for longer term investors or shorter term traders.
ETFs usually require lower minimum investments than Index Funds, although some Index Funds do not have any minimum investment amounts. For smaller account holders, consider an ETF with affordable share price index fund without any minimum investment amount. Investors are also advised to check the account minimum allowed for the brokerage.
ETFs are more tax efficient than Index Funds in that when ETFs are sold, typically selling to another buyer who provides cash. Capital gains taxes on that sale would needed to be paid by seller alone. For index funds, the seller technically must redeem it from the fund manager, who will sell securities to generate the cash, net gains being passed on to every investor with shares in the fund, therefore even non fund sellers may owe capital gains taxes.
Due to the fact that ETFs trade on the stock exchange, ETFs buyers may also incur a cost called the bid-ask spread, which will not be applicable when purchasing Index Funds. However, for high volume and broad market ETFs, this expense is usually minor.
In conclusion, both Index Funds and ETFs offer low-cost options compared with majority of actively managed mutual funds due to lower expense ratios. To decide between various ETFs and Index Funds, it is prudent for investors to compare each specific fund’s expense ratio, check out the commissions and fees and understand the capital gain reinvestment details before transacting the investment.
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