In today’s world of high inflation and low interest rates, prudent investing is crucial to everyone who wants to protect their savings and create wealth. A basic comparison between the returns of the TSX and savings accounts is more than enough to drive the point home. At present, the savings rate in Canada is about 1%, but the CPI inflation rate is at 2.2%, which means that traditional savings will certainly lead to erosion of wealth. Over the past 60 years, the TSX index has returned 9.3% a year on average, which means C$1 invested in 1960 would be C$207 today. While investing in equities is not in everybody’s circle of competency, various passive investing tools are available to retail investors that are simple and very effective.
Most investors don’t understand the magical effects of compounding over long periods of time on wealth. Index Funds and ETFs are the most popular passive investing tools available to retail investors today due to their low fees, simplicity, and effectiveness for wealth creation. Index Funds and ETFs are an almost sure-shot way to massive wealth creation for anyone if used properly. A simple yet mind-boggling fact about the effectiveness of ETFs and Index Funds is that most of the best hedge-fund managers in the world have struggled to outperform them over the past decade.
They offer investors a hands-off investing method with exposure to a growing global economy. They can be used to create a very diversified portfolio with a great risk-return profile. In addition, both ETFs and Index Funds are eligible for the TFSA (Tax-Free Savings Account), RRSP (Registered Retirements Savings Plan), and RESP (Registered Education Savings Plan). In this article, we will explain to you in detail how these investment products work so that you can evaluate which one is a better fit for you. We will also compare both products’ various strengths and weaknesses and highlight the various implications of investing in either.
Broadly speaking, both Index Funds and ETFs are investment vehicles that track popular indexes. An index is a composite/weighted average of a country’s/sector’s best and largest companies. These indexes typically include the biggest companies from core sectors such as banking, steel, cement, power, infrastructure, technology, etc. The value of the index is determined by a weighted average of the company’s market capitalization.
Why Index Funds?
Index Funds or index-tracking mutual funds are investment vehicles that track popular indexes such as the TSX Composite, the flagship index of Canada, and the S&P500 or Dow Jones Industrial Average, the flagship indexes of the US. Of late, the NASDAQ has been one of the best performing indexes globally due to its high weightage of the biggest technology companies in the world, such as Apple, Tesla, Facebook, etc.
Investors do not need a brokerage account to invest in index funds as they are not listed. Index Fund products are generally offered by banks or financial services companies. The fund’s company/bank/manager has the simple job of mimicking/tracking an index. They do this by holding shares of the companies in the index in the same proportion as their weightage in the index. Due to the simplicity of the strategy, index funds are really cheap in terms of fees compared to actively managed mutual funds. However, fees are a massive killer of returns over long periods of time due to compounding. A menial looking 1% or 2% a year fees can wipe out north of a third of an investor’s returns over a long period of time. This is one of the two prime reasons behind the explosion in popularity of passive investment products such as ETFs and index funds. The second is that index-tracking vehicles have outperformed most expertly run hedge-funds in the world in recent times due to ever-decreasing information asymmetry.
When investors decide to invest in an index mutual fund, they pay the investment amount to the index fund provider, who uses it to add more shares of the companies in the index to the fund’s assets. Unlike ETFs, index funds are only redeemable at the end of a day and not during market hours. All dividends paid to the index funds by companies are reinvested immediately. Some funds pay out dividends, but these are rare.
Over the course of a year, the index funds incur various costs such as transaction costs and rebalancing costs. For example, when an investor decides to liquidate their index funds, the fund manager/provider has to sell shares to pay them. This incurs transaction costs due to the bid-ask spread and exchange fees/broker fees along with capital gains tax. Similarly, an index is constantly evolving due to the changing weights of the constituent companies, thus causing the fund manager/provider to constantly rebalance their holdings to track the index as closely as possible.
ETFs are very similar to index funds in a lot of ways. They are both used to track indexes and are low-cost due to the simplicity of strategies. Apart from simple index-tracking ETFs, there are also actively managed ETFs that are increasingly getting popular. These active ETFs usually follow certain themes such as technology or sub-sectors of technology and are managed by expert fund managers. However, active ETFs usually entail higher fees.
The working of ETFs is dramatically different from index-tracking mutual funds. In index funds, the fund manager issues new units of the index fund to the investors when they buy into the fund and use the money invested to buy more shares of the companies in the index. ETFs are closed-ended funds, which means that new funds cannot flow into the ETFs/new investors cannot add to the fund’s pool of assets. If an investor wants to buy into an ETF or sell their holdings in the ETF, they can buy/sell units of the ETF directly from the market as they would for shares of any company as they are publicly listed. While most ETFs are closed-ended, open-ended ETFs also exist.
Also, ETFs have a very different rebalancing mechanism. Instead of buying and selling shares whenever rebalancing is required, the ETFs swap shares of equal value for rebalancing. This results in negligible transaction costs and no tax implications for ETF investors.
In the case of open-ended funds, when a new investor wants to buy into the ETF, their investment is converted into a basket of securities that mimic those held by the ETF and then handed over to the ETF manager. The same goes when an investor in an open-ended ETF wants to liquidate their investment; instead of selling shares and handing over cash like index funds, the ETF manager hands over a basket of securities with the highest unrealized gains, which are then liquidated and paid to the investor by the broker. This shields the ETF from transaction costs and tax implications and passes these costs directly to the investor. This entire system is known as the issuance and redemption in-kind system.
ETFs vs Index Funds
- ETFs, enjoy a clear advantage over Index Funds in transaction costs because of their redemption and rebalancing in-kind process. As a result, the transaction costs are borne directly by the investor who wants to transact and not every investor in the fund. This results in lower expenses for all investors and, in turn, more compounding from the money saved.
- ETFs also beat index funds due to another advantage from the redemption in-kind process that they employ. Index Funds suffer from cash drag because the fund manager has to keep a portion of the fund’s assets in cash to meet daily redemptions. This affects returns in the long run as the money held in cash to meet obligations could have been invested and compounded.
- Index Funds beat ETFs in dividend policy because they can reinvest dividends immediately and let them compound. In contrast, ETFs accumulate dividends and pay them at the end of the quarter. This leads to investors bearing the opportunity cost on funds paid as dividends. Dividend reinvestment is possible in ETFs, but they have to be done by the in-kind process and lead to investors bearing direct transaction costs and the opportunity cost over the quarter every time they reinvest.
- ETFs have a clear advantage in terms of fees due to lower operating costs. As ETFs transact in-kind, they do not have to bear any accounting costs and pass them on directly to the investor through the brokers. Combined with lower transaction costs, they are the cheaper option for investors who want to compound over long periods of time. This is a huge advantage as even menial fees snowball into large amounts over long periods of time due to the effects of compounding.
- While redemptions are cheaper for ETFs than Index Funds from the fund’s perspective, redemptions and new investments are more expensive for the investors in ETFs as they have to bear transaction costs such as commissions bid-ask spreads which are not incurred directly in Index Funds. However, this only matters if someone is buying and selling their investments regularly. Thus, in the case of long-term investors, ETFs are cheaper.
- Taxation policies clearly give ETFs the advantage as they can pass on any tax liabilities directly to the investor. They do so by handing over shares with the highest unrealized gains every time someone redeems their holding. The broker then sells the holdings and hands over the cash to the redeeming investor who pays capital gains tax on their profits. In contrast, due to balancing and redemptions, Index Fund investors have to bear capital gains tax on the constant buying and selling of securities by the fund over their investment tenure. This has a large impact in the long run due to the effects of compounding.
- Liquidity is another strength of ETFs over Index Funds. ETF investors can liquidate instantly during market hours, whereas index fund investors have to wait till the end of the day.
- In most cases, ETFs have lower minimum investments compared to index funds as their units are publicly traded and because their in-kind transaction process gives them more flexibility. In contrast, index funds require a larger minimum investment due to the costs of directly buying more stocks of the tracking index. For example, Canada’s current minimum for index funds is about C$100 a month, while a unit of iShares Core TSX Composite ETF, which is the largest index ETF in Canada, is just C$32.
As you can see, ETFs have a clear advantage over Index Funds in most cases and are the hands-down better long-term passive investing vehicle.
Index Fund Vs Etf
This article discusses what you need to know about index funds and exchange-traded funds (ETFs). That’s why I’m particularly concerned about the difference between an index fund and an ETF. I will focus on the index – ETFs based on it because that’s exactly what they are, unlike their actively managed counterparts. ETFs are managed by matching a type of index benchmark with a range of benchmarks such as the S & P 500, Dow Jones Industrial Average or any other benchmark. Sources: 5, 22
ETFs typically track the underlying index and trade on the stock market, which is considered index funds. Index funds or ETFs try to replicate the index by holding shares in the same proportion as them. Sources: 6, 17
Whether an index fund or ETF will ultimately be better for you depends on the objectives of the particular option you are considering. ETFs, mutual funds or index funds that are the best investment option for your specific investment needs and objectives depend on what you are looking for in an investment. It would be best if you considered whether an ETF or investment fund (or index fund) within a financial plan is a good choice for your investment’s specific objectives and goals. This allows you to focus on a particular index without the need for investment trusts and ETFs. Sources: 4, 14, 15
If you have already chosen an index fund, you will need to decide whether it follows the same index or not. ETFs or index funds have management fees and transaction fees compared to an index – tracking investment funds or ETFs. In general, index funds and ETFs have very low-cost ratios, but that will depend on the index, investment trust and ETF you buy. The cost ratio of an index fund is mostly between 0.2% and 1.5%, whereas it is between 1% and 2% for investment funds. Because index funds are generally bought directly from an investment or brokerage firm, they do not incur brokerage fees (“burdens”). They have substantially lower ownership and management costs (or transaction fees) than when choosing an index ETF that tracks a particular index, such as the S & P 500 or Dow Jones Industrial Average (DJIA). Sources: 3, 19, 20, 22
If ETFs’ biggest advantage over index funds is the cost, I suggest having a demon account and investing in an ETF. To find out if your investment trust has ETF shares, visit the fund page at vanguard.com and also look for – or available – ETFs. ETFs, like index funds, incur broker fees and are therefore significantly more expensive than index funds. Sources: 0, 1, 23
To invest in an ETF or index fund, you need a broker to buy and sell the securities. If you are interested in taking advantage of a market-based investment, this may be a better choice for you. You can also get a little more tax efficiency from ETFs than index funds if you opt for a taxable brokerage account. You are already investing at a lower price, and the lower the rate, the better. Sources: 2, 8, 18, 22
The biggest difference between index funds is listed, bought and sold on the stock exchange. ETFs are traded on an exchange in the same way that ordinary shares are traded on exchanges, so you are no longer exposed to risk in one direction or another. Both mutual funds and ETFs based on the S & P 500 index will perform substantially the same. An investment fund or ETF that tracks the same index will deliver roughly the same returns. Sources: 9, 12, 16
For example, you can buy an index fund based on an investment trust or ETF, both as an investment trust and as an ETF. This is because index funds are always linked to a particular market to be bundled into a single fund. Sources: 7, 9
The other thing you need to know about certain index funds, often referred to as exchange-traded funds (ETFs), is that they can become illiquid if fears arise about the index or the indices they track or track. An index investment fund or index ETF is managed to track the performance of the underlying index fund. This way, you usually know exactly what is in the system. Index funds and most ETFs track an index, but not all are equal. For example, if you track the values of stock indexes, an exchange-traded fund may take a slightly different route to do so. Sources: 11, 15, 19, 20
For example, some ETFs or index funds offer access to bonds, but they can also be offered short selling, unlike open-ended index funds. Sources: 10
If the ETF is trading thin, an index fund is a good option because it creates a more diversified portfolio than the ETF assets. Sources: 8
ETFs and index funds can deliver higher returns over a longer period than individual stocks. However, index funds that replicate the same index tend to offer extremely similar returns for long-term investors. When considering an ETF or index fund, remember that there is no such thing as a “safe-haven” ETF or even a safe haven for short-term investments. Index funds and ETFs can achieve long-term financial success by increasing the price of the index or fund itself. Sources: 13, 18, 21
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