When deciding on how to invest, one question always pops up… What investment tool to choose?
The choice usually would depends on the needs and goals of the individual investor. Other factors you need to consider before diving in investing includes the size of the portfolio, investment time frame, costs to manage your investments, tax implications, flexibility and simplicity. This is where we have positioned Wootrader to help individual investors by giving them a powerful yet easy to use platform.
But there’s an easier way to invest if you don’t have the required time, skills or investing discipline to invest your own portfolio. Let’s take a closer look at two popular investment vehicles today – Index Funds and Index Exchange Traded Funds (ETF). They are also some of the best and most practical investment types for portfolio construction and fund diversification to date.
What is the difference between an index fund and an ETF?
An Index fund is an investment tool designed to replicate the performance of an entire market by acquiring all the shares of a particular index. It is managed by an investment company that handles the transactions and does not require analysts to do research for the best stocks to pick (and analysts are notoriously underperforming the markets).
Exchange traded funds or ETF are a flexible investment tool and requires a brokerage account since the shares are not sold directly by the fund company. The shares are listed and traded on the stock exchange and can be traded through a brokerage account. Trading on a major stock exchange can be done during the trading day.
The benefit of investing in IF and ETF is that they’re both great in terms of passive investing, which is not intended to outperform the market. This removes the risk of committing mistakes and underperforming a standard index. Index funds and ETFs are fairly similar, but each has their own unique characteristics and advantages and the choice to make usually depends on the investment strategy that will work best for the investor.
Investing in index funds allows investors to trade at Net Asset Value (NAV) which are priced once a day at the close of the market. On the other hand, ETFs are priced throughout the day making them very liquid and easy to buy and sell quickly if needed. But the downside here is the spread or the difference between the bid and the ask price which an investor has to pay. Utilizing ETFs in some instances results in investors closing out a position.
Index funds do not have to be traded frequently and with many index funds charging no commission fee. While ETFs incur a transaction fee for every transaction made. Although some brokerage firms are reducing or totally eliminating commissions on ETFs or their own ETFs to make them more attractive.
Cost to invest.
Both index funds and ETFs entail ongoing costs like management fees, fund accounting and pricing fees, administration, distribution charges, and other operating expenses which are all included in what is called expense ratio. And both index funds and ETFs have an exceptionally low expense ratio. “Investors should look for S&P 500 index funds that charge fees of 0.20% or less,” says Michael Rawson, an analyst at Morningstar who tracks S&P 500 index funds. Serious investors must always be aware of the potential loss resulting from high expenses. So, remember, the lower the fee, the better the return.
Tax is another cost to watch out when investing. Sale of index fund or ETF securities that have increased in value will create a capital gain and are paid out to shareholders at the end of the year. This increase in value becomes the basis for taxation.
Tax efficiency differences.
Most investors agree that ETFs are more tax efficient than index mutual-funds. Generally, when trading an ETF whose value has increased, the tax on capital gain is only incurred when the securities being held are sold. Taxes can be delayed and the longer you can hold on to your investment, the better. While in an index fund, tax on capital gains is incurred as soon as profit is realized when trading an equity within the basket.
ETFs are structured in such a way that when investors decide to clear their positions, they simply trade their shares back and forth with other investors instead of cashing in with the fund thereby eliminating tax issues. But with an index fund, securities are sold to raise cash during redemption thus creating capital gain and this can can create tax implications.
ETF trading allows investors to have control over tax issues affecting their investments. With index funds, tax issues are only reduced, but not eliminated as human decisions are taken out completely. It follows periodical investment changes based on sets of rules. This results in less frequent trading and low capital gain tax. One good thing with Index funds is that capital losses and other tax mitigations that have been incurred from prior years can be applied against the current annual capital gain taxes.
The upsurge of indexed funds and ETFs in recent years has made the S&P 500 index the best known benchmark of top U.S. stocks. Companies included in the list have become the most extensively traded assets in the world.
The table below shows some S&P 500 index fund comparative performance.
|Name||Ticker||Structure||Annual Return YTD||S&P 500 TR USD||Expense Ratio||Management Fee||12b-1||Administrative Fee||Tax Ratio 1 YR|
|Vanguard 500 Index INV||VFINX||Mutual Fund||2.59||2.7||0.17%||0.11%||N.A.||N.A||0.84%|
|Fidelity Spartan 500 Index||FUSEX||Mutual Fund||2.64||2.7||0.09%||0.03%||N.A.||N.A.||0.92%|
|Fidelity Spartan 500 Index Advtg||FUSVX||Mutual Fund||2.69||2.7||0.05%||0.03%||N.A.||N.A.||0.86%|
|Schwab S&P 500 Index||SWPPX||Mutual Fund||2.61||2.7||0.09%||0.06%||N.A.||N.A.||0.45%|
|SPDR S&P 500 ETF||SPY||ETF Unit Investment trust||2.65||2.7||0.09%||N.A.||N.A.||N.A.||0.86%|
|iShare S&P 500 Index Fund||IVV||ETF Open Ended Investment||2.65||2.7||0.07%||N.A.||N.A.||N.A.||0.91%|
|Vanguard S&P 500 ETF||VOO||ETF Open Ended Investment||2.68||2.7||0.05%||N.A.||N.A.||N.A.||0.88%|
|Guggenheim S&P Equal Weight ETF||RSP||ETF Open Ended Investment||-0.49||2.7||0.40%||N.A.||N.A.||N.A.||0.70%|
**Data by Morningstar as of 10/31/2015
Determining company size.
Market capitalization weighted index funds - the stocks are weighted by their total market value based on capitalization. Which means that a stock with a larger market cap will have a higher influence in the index basket. It is also a way of showing how the stock market is performing: ~80% of the total market capitalization in the US is formed by stocks included in the S&P 500.
Tracking Funds are basically an index fund that tries to imitate or match the performance of the market index that it tracks like the S&P 500. A form of passive investment where no active management of the portfolio is involved. Since no traditional fund manager has been able to beat the market index consistently, it makes more sense for most investors to just track the index.
Should you choose an Index fund or ETF? Well, for most passive retail investor who don’t have the time and skill to do research and prefer simplicity and low transaction cost, an Index fund would be a logical choice. And for investors who require flexibility and trading convenience, an index ETF will have more advantages.
Remember, the key point here is to evaluate your needs and the reason why you are investing. This will help in determining which investment type is right for you.
S&P 500 References:
Vanguard 500 Index (VFINX):
Fidelity Spartan 500 Index (FUSEX):
Fidelity Spartan® 500 Index Advtg (FUSVX):
Schwab S&P 500 Index (SWPPX):
iShares S&P 500 Index Fund (IVV):
Vanguard S&P 500 ETF (VOO):
Guggenheim S&P 500® Equal Weight ETF (RSP):