Last week, we talked about why you might want to diversify your investments.  This week we’ll take a closer look at how you can do that with two of my favorite investment vehicles — index funds and ETFs. Both offer low-cost, diversified investing strategies that can help you benefit from the ups and downs of the market.  But as with any investment approach, it’s important to understand them before you put them to work.  So let’s look at the basics, including what these vehicles are, how they work and the pros and cons of using them.

What is an index fund?

An index fund is a mutual fund that seeks to match the performance of an investment index.  If the index goes up by 5%, the index fund should go up by the same amount (minus expenses).  If it goes down, same thing.  There are lots of different kinds of index funds, but the most popular track stock indexes.  That is, they invest in the same stocks, in the same proportion, as the index they follow, whether that’s the Dow Jones Industrial Average (the Dow), the S&P 500, the Nasdaq, the Wilshire 5000  or any other index.

These indexes aren’t investments themselves; they reflect the relative value of a group of stocks. In other words, a particular index represents the market average of the stocks it contains. So when people talk about “beating the market,” they are referring to having higher returns than the comparable index.

Although stock index funds are the most well known, you can also find bond index funds, commodity index funds, and funds specific to an industry like real estate.  Here is an example of the Vanguard 500 Index fund (replicating the S&P 500).

Index funds strive to match market returns

Because index funds mirror their respective benchmarks, they strive to match markets returns, not beat them. The mutual fund manager doesn’t try to pick great stocks or eliminate losers.  He or she just keeps the proportion of the stocks in the index fund in line with the stocks in the benchmark index.

By comparison, actively managed funds have a specific strategy that a manager implements to outperform the market. The manager buys and sells stocks, bonds, and/or money market instruments in order to make sure that the mutual fund fulfills its purpose. This buying and selling also takes research, analysis and administration. That costs money.  As a result actively managed funds almost always have higher expenses than index funds.

Benefits of index funds

Index funds provide broad exposure to the market. This broad exposure reduces your investment specific (unsystematic) risk. Index funds also have low operating costs (which benefit your return) and low portfolio turnover (which helps with taxes).

A word of caution though: many types of index funds have been created because of their increasing popularity. They’re not all low cost or diversified. So be aware of the expense ratio of the funds you invest in; many good index funds have operational costs of .05 – .20%. Also choose funds fit your desired asset allocation.

The combination of a diverse portfolio, low tax consequences and low costs make index funds an attractive investment. In addition, since the majority of active funds don’t outperform their benchmarks, they are worth looking into.

What is an ETF?

ETF stands for Exchange Traded Fund. Simply put, ETFs are index mutual funds that can be traded like a stock. The first ETF — the SPDR or Spider — was traded in 1993.  It mimics the S&P 500.

Like index funds, ETFs track a variety of indexes. And as with most investments, ETFs have their positives and negatives.

Benefits of an ETF

Like index mutual funds, ETFs offer many benefits over actively traded funds:

• They have low expenses because they aren’t actively managed. Thus, you get to keep more of your money in your account and boost your earnings.
• Studies have shown the majority of index funds beat actively managed funds over the long-term.
• They have very low turnover thus avoiding large capital gains. That makes them tax efficient. In addition, you can harvest tax losses to offset some of your other gains.
• They help create a diversified portfolio by giving you broad exposure to the market.

In addition to those benefits, ETFs give you access to intraday trading — meaning you can trade at the time and price that you want (or at least close to it) rather than having to wait until the close of business to find out the price of a traditional mutual fund.

Disadvantages of the ETF

The main drawback to ETFs is the commission you have to pay every time you buy or sell one.  So for those of you who dollar-cost average and put in small sums every month, the commission takes a bite out of what you invest each purchase and reduces your overall return.

In addition, some ETFs that are tailored to narrow sectors — emerging markets, clean energy, nanotech — can have higher expense ratios than a corresponding index fund.

Considerations for choosing index funds vs. ETFs  

While these vehicles are similar, there are a few differences that may make one or the other a better choice for you.

First, ETFs tend to have lower expense ratios, which could you save you more money in the long run.  But because ETFs are bought and sold like stocks, you may have to pay a commission when you buy and sell. Therefore, ETFs can be a great pick for buy and hold investors who want to make a large lump some investment in a taxable account. However, people who make smaller investments on a regular basis are usually better off with index funds in a retirement account.

Second, because ETFs can be bought and sold throughout the day like stocks, they provide much more flexibility than index funds, which are priced and traded only once a day.  They also typically have much lower investment minimums than index funds.  You may need several thousand dollars to start an index fund account; $100 or so can buy you a single ETF share.

Lastly, in taxable accounts, ETFs are typically more cost efficient than index funds. This is especially important when it comes to rebalancing your portfolio back to index weightings.  Index funds do this every day, and every time they sell a stock, they incur trading costs and may realize a capital gain for shareholders. The large trading firms that create and oversee ETFs, by contrast, can often rebalance by using stocks and other securities that they hold on their own balance sheets, avoiding transaction costs. Index funds also hold more cash to deal with potential daily net redemptions, which causes some cash drag.

 

As always, the vehicle you choose depends on your personal circumstances. So take into account your overall costs, purpose and strategy when deciding which vehicle works for you.