Passive Investing: Index Mutual Funds vs. ETFs | Rodgers & Associates
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Passive Investing: Index Mutual Funds vs. Exchange-Traded Funds (ETFs)

Investing in equities can be broken down into two basic categories: active and passive. In simple 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 can be found with index funds and exchange-traded funds (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 a portfolio to one or the other can result in lost oppor­tu­nities.

The ratio of active to passive investing is dependent upon a variety of factors that an investor and their adviser must weigh against individual needs. One important factor to consider is the amount of money in taxable accounts versus the amount of money in tax-deferred accounts, such as IRAs. 

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 Chartered 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, Tesla, Alphabet Inc. A (better known as Google), Alphabet Inc. Class C, Berkshire Hathaway Inc. B., Johnson & Johnson, and JP Morgan Chase. The internal expense (or operating expense ratio) for this fund is 0.14%.

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.

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. 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 mainstream, 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 identical top 10 holdings. It has a slightly lower operating expense ratio of 0.03%. 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, we believe, a good choice for taxable accounts.

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 an 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 you would with an index mutual fund. If you place another order for the same fund later in the day, and the market has changed since your first order, 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 key differ­en­ti­ating factor between mutual funds and ETFs.

How does one choose between the two?  To put things into perspective, a long-term investor’s ability to trade intraday is probably of no signif­i­cance to investment strategy or perfor­mance. Knowing the exact price at the time an order is placed may seem important, but it is not a factor over the long term. The positive aspects of being able to trade intraday also have some potential negatives.

Just like mutual funds, ETFs are given a NAV at the close of the market every day. But unlike mutual funds, they are also 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 before. 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. Take a deeper look at our AGILE retirement framework to learn more about how our tax-efficient investment strategies can help to preserve your wealth.

Origi­nally posted February 2018