What do you Look for Before Investing in an Index Fund or an ETF?

Summary

• Index funds and ETFs are passively managed funds
• Can provide an investor with diversification and exposure to many sectors
• Passive investments can lead to better returns in comparison to equity investments when the chips are down
• Important thing to keep in mind: expense ratio, liquidity, quantity, tradability

Index funds and ETF’s (Exchange Traded Funds) are of immense importance when it comes to managing your wealth. For a know-nothing investor, who lacks the understanding of the business and does not have the time to follow the market, it is a good idea to consider taking exposure to the capital markets through index funds and ETF’s.

Index funds and ETF’s are passively managed funds. Investment in these funds provides the investor with diversification as well as exposure to various sectors. An index fund and ETF, both, mimic an index such as FTSE 100. Hence, by investing in these funds, a layman could easily diversify his portfolio without much effort.

Passive investments versus stocks

ETFs/ Index funds are professionally managed, however, one needs to note that big returns can never be guaranteed in any investment, including these. It can be said that the asset/investment managers have professional knowledge, and the returns depend upon the strategy which they deploy. However, the lack of expertise and access to market insights or tools could deter individual investors from reaping benefits.

Another thing to consider for investors seeking regular income is the dividends. A stock might pay or slash/cancel its dividend like many companies have done in the recent times to preserve liquidity and stay afloat during these unprecedented times. However, dividend ETFs/ index funds distribute income consistently based on the earnings by the fund from the stock it holds.

ETFs/ Index funds offer portfolio diversification for the investors, as it has a huge basket of securities. The gains and losses made by each security are offset, resulting in an overall positive or negative return on the investment. Using diversification in stocks is possible; however, it would require comprehensive analysis and expertise; which is not feasible for passive investors.

A stock market index is a snapshot of majority of businesses trading in an economy. These businesses produce goods & services across the economy. With generations passing by, we tend to consume more products & services in comparison to previous generation. Therefore, with passage of time the value of index is likely to rise. Therefore, for a passive investor, investing in index could be a good starting point. This could be done by two investment vehicles: ETF’s and Index funds.

(Source: Refinitiv, Thomson Reuters)

Passive investments can lead to better returns in comparison to equity investments when the chips are down. The above chart represents the stock price comparison of GDX versus FTSE 100 index during the coronavirus crisis. Since the lockdown in March, GDX has rallied, while the FTSE 100 has plummeted by nearly 17 per cent. As evident from the chart, VanEck Vectors™ Gold Miners UCITS ETF (GDX), which tracks NYSE Arca Gold Miners Index has delivered a price return of more than 30 per cent in the Year to Date basis.

Do read: All about Index Fund; nature, benefits, returns & Top five of UK’s Index Funds

Index funds and ETF’s both work on a similar concept of replicating an underlying benchmark index. However, there are certain things that every passive investor must keep in mind.

• Online share dealing/ trading account

ETF’s trade on stock exchanges just like equities. To invest in an ETF, one would require a share dealing account. These trading accounts could cost investors with some annual subscription charges. For a passive investor, it does not make a lot of sense to open an online share dealing account because he is less likely to make investments in stocks and other asset classes through the account. Therefore, an investor can consider investing in index funds, which do not require a trading account, and could be bought directly from the asset management company. Vanguard and IG Share Dealing are two such online share dealing platforms which provide seamless access to these funds.

Do read: Investors Need Not Miss These Top 5 Online Share Dealing Accounts

• Expense ratio

Expense ratio is the charges levied by the fund managers to finance their expenses for managing the fund. While deciding between an ETF and an index fund, it is important to consider the expense ratio. Usually, the expense ratio of the ETF is comparatively lower than index fund. However, buying an ETF might prove to be costly after considering the brokerage charges levied by the trading account. Notably, brokerage charges are levied while buying and selling both. Moreover, a trading account would also mean periodic account maintenance charges. This ratio can make a huge impact on your capital gains, if you hold your investments for longer period.

• Liquidity

Another important factor to consider while opting between Index funds and ETF’s is liquidity as ETF’s are exchange-traded and could be bought from an exchange. This implies that there is a buyer and a seller. Sometimes there is a gap between the number of buyers and sellers in the market. Therefore, the price of an ETF could fluctuate from the underlying value of its assets under management. Hence, when there is a mismatch between number of buyers and sellers in the market, you might end up buying an ETF at a premium and selling it at a discount. ETF’s daily traded volume could be checked from data available with exchange, so that redeeming your investment is hassle-free. Buying a less liquid ETF does not make any sense, because then you might have to sell it at a lesser price. Therefore, for passive investors it is better to opt for index funds and save on brokerage plus annual maintenance charges.

• Quantity

Another advantage of index funds over ETF’s is that they could be bought/sold in fraction of units held. On the contrary, ETF’s could only be traded in whole number of units. Therefore, index funds could be bought by cash poor investors or people looking to buy in small amounts or instalments.

• Tradability

ETF’s could be traded during market hours. On the flip side, index funds are bought or sold at closing price (NAV). ETF is better in terms of tradability when compared to index funds. However, considering the horizon of your investment, in case it is for the long-term, the benefits of tradability would not make much of an impact on your investment decision.

For a passive investor, investing in ETF’s or index funds could be a great starting point. Regular income seeking investors can opt for dividend paying ETF’s or index funds. Some sectors such as technology, pharmaceuticals, utilities, and essential services had been up and running during the unprecedented times and could be evaluated. Investors who are looking to take indirect exposure into these stocks might consider sector specific ETF’s or index funds. The bottom line is that the investor needs to find a way of investing in index through cost-effective method because as the saying goes: ‘money saved is money earned’.