Passive Investing: Index Mutual Funds vs. Exchange-Traded Funds (ETFs)

There are two types of mainstream passive investment tools, index mutual funds and exchange traded index funds (ETFs). In this post, we compare the two.

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Investing in equities can be broken down into two basic categories: active and passive. In the simplest of terms, an active strategy involves buying and selling, while a passive strategy involves buying and holding. With regards to mutual funds, the active strategy is often referred to as an actively managed fund, and a passive strategy is often referred to as an index fund or ETF

We believe that the tax efficient equity strategies we build for our clients should include both active and passive investment vehicles because different circumstances indicate different solutions. Limiting yourself to one or the other can result in lost opportunities.

The proportion of active vs. passive is dependent upon a variety of factors that you or your adviser must weigh to match your individual needs. Let’s explore two mainstream passive investment tools: index mutual funds and exchange traded index mutual funds, commonly known as passive ETFs.

Index Mutual Funds

One well-known index mutual fund on the market today is managed by a team of Certified Financial Analysts. The fund invests in the stocks that comprise the S&P 500 index with the top ten holdings by portfolio weighting including, as I write this, Apple, Microsoft, Amazon, Facebook, Johnson & Johnson, JP Morgan Chase, Berkshire Hathaway Inc. B, Exxon Mobil, Alphabet (better known as Google), and Bank of America. The internal expenses, or Operating Expense Ratio, for this fund is .14%.

As with any index fund, the management team is not assigned the task of evaluating or researching the different stocks it holds. The fund will only buy the stocks that make up the index the fund will be tracking in the proportion they are represented in the index. One of the reasons the cost is so low is there is no research necessary to determine the fund’s holdings.

How Mutual Funds are priced

All mutual funds, including index funds, are bought and sold based on the Net Asset Value (NAV). The NAV is the price you pay per share. The NAV is calculated each day at the market close.

Here’s how it works: Every day at the close of the market, the value of all the stocks held by a fund are added together and then divided by the number of shares outstanding. This value equals that day’s price – or NAV (net asset value).  This price is fixed until the next business day’s market close, at which time the NAV is calculated again. Any trades placed during the day will all be priced at the NAV determined at the close of the trading day. Some days the NAV increases, some days it decreases. Funds tend to be purchased in terms of dollars rather than shares.

Exchange Traded Funds (ETFs)

The first ETF was launched in the US in 1993, but they did not become popular with retail investors until the early 2000’s after the “Tech Wreck”.  Today ETFs are incredibly main stream with almost every major fund family offering a robust menu of these passive style investment options to choose from.

The S&P 500 Index fund mentioned above has a corollary S&P 500 ETF that is managed by the same team leader and has the same exact top 10 holdings. It’s operating expense ratio is slightly lower at .04%. From an investment standpoint, the index fund and the Exchange Traded Fund are virtually the same. They accomplish the same things:  low cost and passively managed exposure to the stocks that comprise the S&P 500. And because they are both passive investments (aka buy and hold) they are both very tax efficient and an excellent choice for taxable accounts.

What is the difference between an index fund and an ETF?

The difference can be summed up in two words: intraday trading. Unlike mutual funds, ETFs can be bought and sold anytime throughout the day. If you enter an order to buy the ETF on Tuesday at 10:15am EST and the market is down, you will get the price based on the value of the underlying securities at that point in time as opposed to the end of the trading day like index mutual funds. If you place another order for the same fund later in the day and the market changes, you will get a price per share that reflects that change. Being able to buy and sell at any time during market hours is the most differentiating factor between mutual funds and ETFs.

How do you choose between the two? To put things into perspective, if you are a long-term investor, the ability to trade intraday is of no significance to your investment strategy or your performance. Knowing the exact price at the time you enter your order may seem important but is actually not a factor over the long term. The positive aspects of being able to trade intraday also has some potential negatives.

Just like mutual funds, ETFs are given a NAV at the close of the market every day, but throughout the day, they are assigned an Intraday NAV (iNAV) that is updated every 15 seconds. Because ETFs are traded on the exchange, there is always an ask price (buyers get this price) and a bid price (sellers get this price).

The difference between the bid and the ask is called the spread. Under normal circumstances, the iNAV should be equal to the value of all the underlying securities divided by shares, just like the NAV calculation at the end of the day. During times of significant market volatility, however, the bid or ask price may be skewed due to trade flow so a trade executed during that time could be purchased at a premium to iNAV or sold at a discount to iNAV. iNAV might also be inaccurate if a stock held within the ETF has halted trading for whatever reason. When trading is halted, the best quote for that stock is the last one, and that could have been hours ago. If iNAV is updated every 15 seconds, it’s likely going to be inaccurate while trading is halted on any of the underlying stocks.  Fortunately, these deviations from iNAV are typically short lived.

The bottom line is that index mutual funds and ETFs are similar in structure, but differ in trading and frequency of assigned value. At Rodgers & Associates, we use both types of passive investments in our portfolios because of their tax efficiency, low internal expenses and diversification. Learn more about how our tax-efficient investment strategies can help to preserve your wealth.

 

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