Index Funds An index fund is a “passively” managed mutual fund that tries to mirror the performance of a specific index, such as the S&P 500 or the Dow Jones Industrial Average. Since index funds attempt to mirror a stock index, decisions about which stocks to buy and sell are automatic for the fund and transactions are infrequent. This means that index funds do not require the management of a professional money manager, and so they are said to be “passively managed” (while any fund that requires a manager to select stocks is said to be “actively managed”). Index funds have become increasingly popular with investors over the past few decades for a variety of reasons. First, the funds have much lower operating expenses than actively managed funds. This is because passive funds do not require the services of a professional money manager to select stocks for the fund’s portfolio; instead, they simply buy and sell according to the holdings of a particular index. And, since most indexes do not often change their holdings, index funds benefit from lower transaction costs and fewer capital gains taxes in addition to the lower management costs. Many investors also like index funds because they do not have to worry about “beating the market” since they can choose to invest in an index that mirrors the market (either the market as a whole or some specific part of it). But although you’ll never significantly underperform the market with an index fund, you’ll also never have the opportunity to significantly outperform it. Even so, as more and more studies have shown that most mutual fund managers are unable to beat the market consistently, more and more investors have been starting to take advantage of index funds. For individuals who don’t have the time or interest to select and monitor a portfolio of actively managed mutual funds, we recommend seriously considering index funds. Exchange-Traded Funds Exchange-traded funds (ETFs) are similar to index funds, but with one important distinction: they trade on stock exchanges. When you buy a share in an ETF, you are buying a share in a unit investment trust or another type of trust . In order to create an ETF, the trust bundles together many different securities into one basket and then sells shares in the trust on a stock exchange. ETFs always bundle together the securities that are in an index; they never track actively managed mutual fund portfolios (because most actively managed funds only disclose their holdings a few times a year, so the ETF would not know when to adjust its holdings most of the time). Investors can do anything with an ETF that they can do with a normal stock, such as short selling . Because ETFs are traded on stock exchanges, you can buy and sell them at any time during the day (unlike most mutual funds). Their price will fluctuate from moment to moment, just like any other stock’s price, and you’ll need a broker in order to purchase them, which means that you’ll have to pay a commission. On the plus side, though, ETFs are more tax-efficient than normal mutual funds, and since they track indexes they have very low operating and transaction costs associated with them. There are no sales loads or investment minimums required to purchase an ETF. The first ETF created was the Standard and Poor’s Deposit Receipt (SPDR, pronounced “spider”) in 1993. SPDRs gave investors an easy way to track the S&P 500 without buying an index fund, and they soon become quite popular. Shortly thereafter, a number of other ETFs came onto the market, including “cubes” (which track the Nasdaq 100 under the symbol QQQ) and “diamonds” (which track the Dow under the symbol DIA). Today you can buy ETFs for dozens of different indexes. Index Funds vs ETFs Given the increased popularity of exchange-traded funds (ETFs), you would think that index investors have fallen in love with this investment vehicle. Even though ETFs have only been around since 1993 (whereas the first index mutual fund was introduced in 1975), by the end of 2004 their total net assets amounted to almost half those of index funds (see Table 1). However, a closer look shows that index funds are still the top choice for the majority of retail index investors. Here we will look at the reasons why ETFs have become so popular and analyze whether they make sense – from a cost, size and time-horizon standpoint – as an alternative to index funds. Table 1 – Comparison of types of funds Many articles have been written comparing ETFs to index funds, but not much has been written on quantifying the differences to determine when one makes sense over the other. (For an overview of both investments, see Introduction to Exchange-Traded Funds and The Lowdown on Index Funds.) In an article entitled “Index Mutual Funds and Exchange-Traded Funds”, published in the Journal of Portfolio Management in the summer of 2003, Leonard Kostovetsky actually quantifies those differences by looking at the explicit and implicit costs inherent in both ETFs and index funds. Comparing the Advantages Because ETFs are flexible investment vehicles, they appeal to a broad segment of the investing public. Passive investors and active traders alike find the features of ETFs attractive. (To learn more see, Advantages Of Exchange-Traded Funds.) Passive institutional investors love ETFs for their flexibility. Many see them as a great alternative to futures. For example, ETFs can be purchased in smaller sizes. They also don’t require special documentation, special accounts, rollover costs or margin. Furthermore, some ETFs cover benchmarks where there are no futures contracts. Active traders, including hedge funds, love ETFs for their convenience, because they can be traded as easily as stocks. This means they have margin and trading flexibility that is unmatched by index funds. Ironically, ETFs are exempt from the short sale uptick rule that plagues regular stocks (the short sale uptick rule prevents short sellers from shorting a stock unless the last trade resulted in a price increase). Passive retail investors, for their part, will love index funds for their simplicity. Investors do not need a brokerage account or deposit with index funds. They can usually be purchased through the investor’s bank. This keeps things simple for investors – a consideration that the investment advisory community continues to overlook. Comparing the Costs ETFs and index funds each have their own particular advantages and disadvantages when it comes to costs associated with index tracking (the ability to track the performance of their respective index) and trading. The costs involved in tracking an index fall into three main categories. A direct comparison of how these costs are handled by ETFs and by index funds should help you make an informed decision when choosing between the two investment vehicles. First, the constant rebalancing that occurs with index funds because of daily net redemptions results in explicit costs in the form of commissions and implicit costs in the form of bid-ask spreads on the subsequent underlying fund trades. ETFs have a unique process called creation/redemption in-kind (meaning shares of ETFs can be created and redeemed with a like basket of securities) that avoids these transaction costs. Second, a look at cash drag – which can be defined for index funds as the cost of holding cash to deal with potential daily net redemptions – favors ETFs once again. ETFs do not incur this degree of cash drag because of their aforementioned creation/redemption in-kind process. Third, dividend policy is one area where index funds have a clear advantage over ETFs. Index funds will invest their dividends immediately, whereas the trust nature of ETFs requires them to accumulate this cash during the quarter until it is distributed to shareholders at end-of-quarter. If we were to return to a dividend environment like that seen in the 1960s and ’70s, this cost would certainly become a bigger issue. Non-tracking costs can also be divided into three categories: management fees, shareholder transaction costs and taxation. First, management fees are generally lower for ETFs because the fund is not responsible for the fund accounting (the brokerage company will incur these costs for ETF holders). This is not the case with index funds. Second, shareholder transaction costs are usually zero for index funds, but this is not the case for ETFs. In fact, shareholder transaction costs are the biggest factor in determining whether or not ETFs are right for an investor. With ETFs, shareholder transaction costs can be broken down into commissions and bid-ask spreads. The liquidity of the ETF, which in some cases can be material, will determine the bid-ask spread. Finally, the taxation of these two investment vehicles favors ETFs. In nearly all cases, the creation/redemption in-kind feature of ETFs eliminates the need to sell securities – with index mutual funds, it is that need to sell securities that triggers tax events. ETFs can also rid themselves of capital gains inherent in the fund by transferring out the securities with the highest unrealized gains as part of the redemption in-kind process. Table 2 – A comparative look at the costs associated with index funds and ETFs, with 1 indicating the greatest effect on costs and 4 the least. Which Investment Will You Choose? Typically, the choice between ETFs and index funds will come down to the most important issues: management fees, shareholder transaction costs, taxation and other qualitative differences. According to the analysis we mentioned earlier by Kostovetsky, a comparison of these costs favors index funds as the choice for most passive retail investors. Kostovetsky’s analysis assumes no tracking costs and the more popular indexes. For example, if you were looking at a holding period of one year, you would be required to hold over $60,000 of an ETF for the management fee and taxation savings to offset the transaction costs. With a longer-term time horizon of 10 years, the break-even point would be lowered to $13,000. However, both these limits are usually out of range for the average retail investor.