Are ETFs or Indexed Funds Better for the Passive Investor?Submitted by Gerstemeier Financial Group, LLC on July 20th, 2018
ETFs and indexed mutual funds are emerging as the investment of choice for investors who are discovering the virtues of passive investing. Not surprisingly, they have both seen an explosion of growth and are especially popular choices for retirement plans and investors with a long time horizon. With all of the attention they are garnering comes the question as to which investment option can generate the best long term results. While they both have similar the similar investment objective of tracking the performance of the underlying stock or bond index, they operate in distinct ways that can produce different results depending on your own particular investment objective.
A Difference in Costs
While cost shouldn’t be your only determinant for choosing one investment option over another, it certainly is contributing factor. One of the primary reasons both ETFs and indexed funds are growing in popularity is their relatively lower cost. A straight-across comparison between the two would show that ETFs generally have lower expense ratios than indexed funds, sometimes by as much as half. Whereas an indexed fund might charge .15% (which, by the way is a fraction of what regular mutual funds charge), an ETF might only charge .07%. Over time, the difference of .08% can add up especially as your fund value continues to increase.
There is another factor, and that is transaction fees. If the purchase or sale of units in an ETF or indexed fund involves a commission, that is usually not factored into their expense ratio, so they have to be considered separately. Many of the best indexed funds don’t include any sales charge if they are purchased directly. ETFs have to be purchased through a broker who may charge a commission or transaction fee. If you use a discount broker, the costs can be minimal, sometimes as low as $5 per transaction. Having said that, there are more and more discount brokerages that are completely waiving transactions fees for some ETFs.
Investment Size Matters
If you plan on investing a lump sum amount, over $2,500, then your investment size need not be a concern. Most indexed funds do require a minimum investment in that range (investment minimums may be lower for retirement plans). Depending on the fund, subsequent purchase minimums vary but can be as low as $25. There is no minimum purchase requirement for ETF units or shares. They are simply purchased on the stock exchange and any dollar amount may be invested. The only issue is what, if any, transaction fees are charged on each purchase which could eat into your account value.
Tracking the Market
Both investment options are designed to track performance of an underlying index. The portfolios of ETFs and indexed funds are comprised of a basket of securities that, essentially, reflect the securities listed on an index with appropriate weightings for each of the holdings. And, both are priced based on the fund’s net asset value (NAV) at the end of each day. This is done by dividing the total number of shares into the total value of the fund.
Because ETFs are traded on the open market, their share prices are affected by investor sentiment which means that they can trade at a premium or a discount to the NAV. If investors are sensing a market upswing, they may trade up the share prices of an ETF, and, likewise, if their outlook is negative it could drive share prices below the NAV. Generally, the more widely traded an ETF is, the more in sync the market price is with the NAV. Some would argue that the fluctuation of ETF share prices will more closely reflect the funds actual value at any given time. One measure of an ETF is its monthly premium/discount percentage which will show you the funds share price history relative to its NAV. Funds with a share price history that diverges widely from its NAV average should probably be avoided.
The Taxing Issue
Both ETFs and indexed funds tend to be much more tax efficient than actively managed mutual funds because the portfolio turnover is very low. That means that there are fewer taxable capital gains that flow through to the investor. This is one reason why both investment options should be held outside of a qualified retirement plan. In the long run, ETFs manager have more tools at their disposal to increase their tax efficiency even more.
Ultimately, the decision to own one investment option over another should be based on your particular circumstances, needs, and objectives. A long term investment strategy might include both ETFs and indexed funds in order to achieve optimum diversification across several market segments. Your financial advisor has the tools to help you determine the best mix of investment options for achieving stable, long-term returns.
*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by Advisor Websites to provide information on a topic that may be of interest. Copyright 2014-2015 Advisor Websites.