When Being A Couch Potato Pays Off: ETFs vs Index Funds
When the party arrived at the Battery, one of his guides indicated some handsome ships riding at anchor.
He said, 'Look, those are the bankers' and then brokers' yachts.'
'Where are the Customers' Yachts?' asked the naive visitor."
-Fred Schwed
What's The Difference?
For greenhorn investors like me, when deciding to invest in ETFs, the first question that comes to my mind is, "What's the difference between ETFs and Index Funds?
While I'm at it, I'll talk about actively managed mutual funds as well.
It takes a good amount of effort in reading up and looking up what is available in the market in order to know the difference, and what you should invest in. I'll simplify what I've learnt in this post.
Why Index Funds?
If you think that Exchange-Traded Funds (ETF) and Index Funds are the same, you're not that far off. In fact, they're so similar that it's hard to distinguish the difference.
An index fund is generally a mutual fund (one of many types) that is designed to track a specific market index (the most common in Singapore is the STI). This market index typically represents an entire stock market, and as you can tell, means that it consists of a number of stocks. The STI comprises of shares from the top 30 companies in the Singapore Exchange. A better known foreign market index is the S&P 500 Index, and as the name suggests is the top 500 large-cap US stocks.
If you're smart as a cookie, you would notice that it means your units will never go to 0 unless all 30 (STI) or 500 (S&P) companies goes bust. If not, your money is in a safe place 99% of the time. If one company folds or underperforms, another will take over.
An index fund tracks such a market index, which means lesser management is needed, thus the expense ratio and fees payable is much lesser compared to actively managed funds. It's a form of passive investing, which is my (our) exact goal in mind as it requires little attention and just some rebalancing at the end of every year.
Some of us may have met with financial advisors that sells you investment policies that invests heavily in mutual funds/unit trusts (both are similar except for legal structure), and the thing that entices you the most is their performance graph, or past year returns of 10% or more. This is the point where most people take the bait.
Firstly, they fail to take into account the hefty fees charged by the advisor and belittle the percentage charged (I've shown how 1% can cost you a whole deal in this post).
Secondly, they fail to recognise that past or recent returns are not indicative of the future. If you think that mutual funds when actively managed can beat index funds, let me lead you to the light at the end of the tunnel. The New York Times back in the 1990s held a competition for 5 well-known financial advisors to pit against the S&P Index Fund to see if they could beat the returns. They were allowed to switch funds at no cost and assumed a tax free account, so it's very fair. It was supposed to last for 20 years, but it stopped at the seventh year. Why?
The results? To your surprise (but not to real financial experts), the S&P Index crushed the competition. The 5 advisors started with $50,000 each and averaged about $138,000, with the lowest at $111,815 and the highest at $155,095. The S&P Index on the other hand had returns of $188,765, crushing the highest earning advisor by $30,000. That's right, a fund left passively managed beat 5 advisors that managed funds actively. Note, this is excluding fees that fund advisors usually charges. With fees included, the profit margin is much less.
Just to note, even if both funds were to profit at an equal percentage annually, the S&P Index still crushes active funds by a huge percentage. Don't take my word for it, take John C. Bogle's (Founder of Vanguard Group, which at present has one of the smallest expense index fund) word. In his heavily worded letter to the New York Times about this competition, he mentions:
"Put another way, the advisers earned a seven-year profit for their retirement plan investors of $88,500, compared with $138,750 for the index fund. That $50,000 difference is enormous -- equal to the entire initial investment. But it understates the reality. For, given the magic of compounding, even if the fund advisers and the index fund were to earn an identical, say, 10 percent a year over the next 13 years, the final value in 2013 would be: average adviser, $478,000; index fund, $652,000."
That's right, the index fund crushes any actively managed fund, and mostly not just due to bad fund switches, but to exorbitant fees charged for managing those funds.
There are advisors that has outperformed the index fund, but they are rare. I won't discount the fact that an advisor can defeat an index fund, but I would learn my lesson from the 90% that doesn't. If you were to argue that "my advisor has beaten the STI Index for the past 3 years", it's definitely possible. But considering the fees, he/she has to beat the index by 3-5% (or even higher) just to generate the same returns after fees payable. Also, past performance is never indicative of the future, so be wary of this.
So, what is an ETF?
Now that you know what an index fund is and why it's probably better than an actively managed fund, here's the main differences between and ETF and an index fund.
An ETF tracks the performance of an index fund to the closest it can (probably off by a very small percentage point most of the time). However the main difference is that they are listed on the market and can therefore be traded like stocks. This means that the prices can go up and down throughout the day and provides liquidity, and similarly they can be bought or sold throughout the day (although doing that would be foolish). Also, it is sold in smaller sizes than index funds, which allows small time investors like us to share a piece of the cake.
Index funds however, can only be marketed once a day, at the end of the day when the market closes. It is normally sold in larger sizes so you would need bigger capital.
Retail investors like me and you should typically choose an index fund over ETFs as the costs are generally lower, however they may be a little more troublesome as it cannot be sold as and when during the day (which is not an issue because we want to invest for the long term) and may have documentations and accounts to be set up before purchase.
In my view, since an ETF mirrors an index fund, both are great options (and are technically the same) and it's up to the individual to decide which he/she wants based on cost, capital and how hassle-free it is.
Conclusion
I would choose an ETF for now as it fits my investment commitment monthly and the fees are not too far off compared to an index fund. Also, it is hassle-free and can just be sold as and when I like it to, which is a huge bonus for me. Personally, I feel that the differences are almost insignificant and to decide which is better, the main point is always to figure out which costs lesser. However for me, I'm supportive of an ETF just because it is more flexible, but it's totally up to you. Small cost difference in exchange for flexibility, I'll take it!
In my next post, I'll share about the bonds, and how I allocate my bonds and index funds. Stay tuned!
Comment if you have questions, opinions or feedback!
-WC
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