As we follow the path of wisdom and logic toward our ultimate portfolio, it makes sense to explore the usage of Index Funds and Exchange Traded Funds (ETFs). We will find that the "truth" is that one is not necessarily "better" than the other but an intelligent investor will know "why, how, and when," to leverage one or the other (or both) for their benefit.
In the previous "Invest Like a Philosopher" post, our logical path led to the conclusion that a prudent investor may leverage the knowledge of others (fund managers) for competitive returns while minimizing market risk and volatility through a strategically diversified investment portfolio. The underlying wisdom here assumes that the investor, like a philosopher, is highly knowledgeable of his or her own ignorance and wishes to greatly reduce the time, energy, and resources needed to wisely invest in individual securities, thereby freeing up more time to pursue his or her true passions.
Considering the "Efficient Market Hypothesis" (EMH) we also arrived at the conclusion that a prudent investor would use "passively managed" investments, such as Index Funds and ETFs, for the most "efficient" segment of the market --large cap stocks. For all other segments, investors should use "actively-managed" funds.
Now that we have fundamentally answered the "why and how" to utilize Index Funds or ETFs we may address the root of this post's lesson: When should an investor use an Index Fund and when should an investor use an ETF?
First, the EMH supports our conclusion that we should only use Index Funds or ETFs for large-cap stocks. Second, we must fully understand the similarities and differences as well as the strengths and weaknesses between the two so we will know when to use them and which one is best for a particular purpose:
- Both Index Funds and ETFs are designed to track the performance of a given benchmark or "index." For example, many index funds and ETFs follow large, familiar indexes such as the S & P 500.
- Both Index Funds and ETFs have low expenses: According to Morningstar, the average Index Fund expense ratio is .65% while the average ETF expense ratio is .40%.
- Most Index Funds and ETFs are "passively managed," which means that the fund manager does not have discretion as to which stocks to buy or sell and when to do it. Once again, Index Funds and ETFs are designed to mimic the performance of their given benchmark or index.
- There is one fundamental difference: Index Funds trade like other traditional mutual funds -- investors buy or sell funds and receive the closing price at the end of the day. ETFs trade intra-day on an exchange like an individual stock with prices fluctuating throughout the day.
The most notable strengths of ETFs:
- ETFs are transparent. This is true in two ways. First, the holdings in an ETF are clearly identifiable, allowing an investor to customize their portfolio with pinpoint accuracy.
- ETFs are tax efficient. From a capital gains perspective, portfolio turnover is relatively low and fund managers are not required to liquidate positions to raise cash when shareholders sell as with Index Funds. ETF investors don't have to take capital gains distributions at the end of the year as they would with a mutual fund. They only have tax liability when they sell the ETF.
- As previously noted, ETFs are cost-effective because of low management expenses.
- In taxable accounts, ETFs may be used for "tax-loss harvesting." You can sell an under-performing mutual fund and claim a tax loss, but maintain exposure to the mutual fund,s market segment or sector by buying an ETF. You may then repurchase the mutual fund after 31 days to avoid the "wash rule."
- ETFs may also be used for hedging or "selling short" but I do not recommend these strategies for the average investor. A properly diversified portfolio will not need to apply these strategies.
The most notable weaknesses of ETFs:
- Since ETFs trade like stocks, there are brokerage commissions attached to each trade; therefore, ETFs are not advantageous for frequent trading or dollar-cost averaging since the commissions will erode at any cost advantage inherent with the ETF.
- ETF investors should "watch the spread," which refers to the price differential between what buyers pay and what sellers receive for a certain security. This is especially apparent with thinly traded issues: The spread might be only a penny on widely traded ETF issues while it may be as high as 50 cents on thinly traded issues.
- ETFs are a hot trend. In the aftermath of a market pullback, many of the trendiest ETFs, especially the smaller poor-performing funds, are at danger of being merged away or closed. Furthermore, the ETF boom has created a wave of new exotic and untested strategies that may increase market risk.
- For tax-deferred accounts, such as IRAs and 401(k)s, the tax advantages of ETFs are removed.
When to use ETFs and when to use Index Funds:
- As a reminder, both funds track a given benchmark or index, which means most ETFs and Index Funds alike are "passively managed." The greatest advantage to a passively managed approach is with the "efficient" areas of the market -- large cap stocks.
- ETFs are ideal in taxable accounts and when trading is infrequent. That way, the investor can leverage both the tax advantage and cost advantage (minus excessive commission costs) mentioned previously in this post.
- Avoid thinly traded ETFs, narrow sectors, and trendy, untested, strategic funds. You could get burned when the market turns down. What's more, those outstanding performance numbers may be a result of short-term market conditions that favor a given sector -- not long-term strategies that have stood the test of time. Do you remember the fate of technology funds following their explosive popularity in the late 90's? Think about that...
- Use Index Funds in tax-deferred accounts and in taxable accounts when there is frequent trading, such as dollar-cost averaging.
Stay tuned as we continue the discussion of how to "Invest Like a Philosopher..."
TFPAuthor, Kent Thune, is the President and Owner of Atlantic Capital Investments, LLC (ACI), a fee-only, registered investment adviser based in Mount Pleasant, SC, near Charleston. ACI specializes in retirement, investments, and comprehensive financial planning.