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Index Funds vs ETFs
Index funds are mutual funds that are passively managed and track an index. This can create some confusion as mutual funds are usually actively managed, while exchange traded funds (ETFs) are usually passively managed. This post should help you understand the distinction between index funds and ETFs.
Mutual funds (including index funds) and ETFs are both types of professionally managed funds that pool capital from multiple investors. The biggest difference is that while ETFs are listed and traded like shares, mutual funds are not.
Actively managed funds are managed by a fund manager who makes investment decisions on an ongoing basis in an attempt to outperform an index, or ‘the market’. By contrast, passively managed funds are designed to mirror an index so that the performance of the fund tracks the performance of the index as closely as possible. Passive investing is also known as indexing – in fact, the term indexing was coined first.
One could actually say that ETFs are index funds since they are funds that track an index. However, the term index fund is typically used to refer to passively managed mutual funds – and for the purposes of this post when we say index fund we are referring to index-tracking mutual funds.
The History of Index Funds
The first mutual funds were launched during the 1920s. It wasn’t until 1975 that the first index fund was launched – though this was still some 18 years before ETFs emerged.
The first index fund was launched by Jack Bogle who many regard as the father of passive investing. The fund which tracked the S&P 500 index was initially called the First Index Investment Trust. Its name was later changed to the Vanguard 500 Index Fund, and it still exists today, though it is closed to new investors.
Differences between Index Funds & ETFs
Index funds and ETFs perform the same function, and from the point of view of the fund manager, there is actually very little difference. However, from the point of view of investors, there are some differences due to their legal structure and the way they are traded. For a more comprehensive breakdown of the differences between mutual funds and ETFs, you can read our previous post on the topic.
The following are the notable differences between index funds and ETFs from an investor’s perspective.
Index funds are priced once each day, and any transactions are based on the NAV (net asset value) of the fund at that time. When you invest in an index fund or redeem your units of an index fund, the transaction will be based on the exact value of the assets those units represent.
ETFs are listed on a stock exchange like other shares and trade throughout the day. When you buy an ETF, you pay the offer price and when you sell an ETF you receive the bid price. The offer price will typically be slightly higher than the NAV, while the bid price will typically be slightly lower than the NAV. The bid-offer spread is therefore an additional expense for ETF investors. The more liquid an ETF and its underlying securities are, the closer the fund will trade to its NAV, and the narrower the bid-offer spread will be.
As mentioned, ETFs trade throughout the day, while index funds are only traded once per day, usually at the closing price. This means that only ETFs are suitable for active traders. In fact, anyone wanting to time their trade during the course of a day will need to trade ETFs.
You can also trade ETFs with a limit order, which means your trade will only be executed if it reaches the price you are happy to trade at.
Because ETFs are traded on a stock exchange, a commission is payable to the stockbroker. This used to be a major issue, but commissions are now very low and only make a sizable difference if the value of the trade is quite low.
Some index funds do charge upfront commissions, but it’s also possible to find an index fund that doesn’t charge commission.
ETFs usually distribute all dividends paid by the companies in the fund to investors. If you want to reinvest that money in the fund you will have to buy new shares, and you will have to pay another commission to do so.
Some index funds automatically reinvest dividends in the index stocks. This means distributions are reinvested on your behalf, commission-free. These funds are called accumulation funds, while distribution funds pay dividends on to investors.
Minimum trade size
The minimum trade size for ETFs is the value of one share. Mutual funds typically have a minimum amount that can be invested. This will depend on whether it’s a lump sum investment or a recurring debit order – but the minimum can be anywhere from $50 to $10,000. Having said that, for most indexes, you will probably find an index fund at the lower end of that scale.
You can also invest in an index fund using regularly scheduled direct debits. This is possible but slightly more complicated for ETF investors.
Recommended ETF Broker
For the most part index funds and ETFs serve the same purpose, though the slight differences mean there are some situations where one is more suitable than the other. ETFS are usually better suited to active investors and investors who want more control over execution. Mutual funds are well suited to longer-term investors and those that want to invest at regular intervals using a direct debit.
Richard Bowman is a writer, analyst and investor based in Cape Town, South Africa. He has over 18 years’ experience in asset management, stockbroking, financial media and systematic trading. Richard combines fundamental, quantitative and technical analysis with a dash of common sense.
With thousands of ETFs available to investors, choosing the right fund can be a daunting task. But it doesn’t have to be – if you take it step by step you can quickly narrow the list down to those that best meet your needs.
Your first step should be to make sure you know exactly what ETFs are, their objectives, and the different types of funds available. We covered these topics in detail here.
When searching for suitable ETFs you can use fund screeners like ETFdb, ETF.com or Yahoo’s screening tool. With these tools you can begin filtering the list according to the fund characteristics listed below.
Index Fund ETFs
Passively managed ETFs – which is most of them – track an index. So, when you invest in an ETF, what you are really doing is deciding to track an index. So deciding on the right index track is the most important step.
If you are about to make your first investment in ETFs, your immediate goal should be diversified exposure to stocks. The stock market has outperformed all other asset classes over the long term and very few investors manage to beat the returns of headline stock market indexes. For this reason, your starting point should be an ETF that tracks a headline index of the largest companies.
For most investors, the S&P500 index is a good place to start, as it includes the 500 largest and most successful companies in North America. However, you could also consider a global index like the MSCI world index. You could also spread your investments across a US index, a European index, and a global index.
Bear in mind that some global indexes exclude US stocks, while others don’t. If you only want to invest in one global fund, then you should include one with US exposure. If you want to invest in a US fund and a global fund, a global ex-US fund would be more appropriate.
Some ETFs track indexes that are constructed specifically for the fund. That is fine, but you should check that the index is weighted by market capitalization and includes at least 75% of the value of all listed stocks in a given market.
Obviously, there are lots of other ETFs that don’t track broad market indexes. Some funds track specific asset classes, sectors, regions, or countries, while others filter securities by other criteria. These funds can all be added to a core portfolio of general equity ETFs to try to improve on performance or reduce risk.
This is where your knowledge and experience come in. As you learn more about investing, you can add more sophisticated products to your portfolio. To start with you may want to add a bond ETF, and increase your exposure to one or two sectors, but you shouldn’t be in a rush to do more than that.
Performance and tracking error
Most investment products come with a warning along the lines of “past performance may not be indicative of future performance.” This is as true for ETFs as it is for any other product. In fact, the recent performance of an ETF shouldn’t really be a concern at all.
The objective of passive investing is to passively track the performance of the stock market – not to chase the funds that performed well recently.
For ETFs something that does count is the tracking error. This measures the difference between the performance of the fund and the performance of the index it tracks. Tracking error results from certain trading expenses and liquidity issues in the underlying market. If an index includes securities with low liquidity, the tracking error is likely to be higher.
Minor tracking errors are to be expected and usually make little difference to performance over the long term. However, if the tracking error is more than 1% a year, you may want to pay closer attention.
The tracking error needs to be considered along with the objectives of the fund and the index performance. If an index returns 50% and the tracking error is 2%, that’s not a very big deal. But if an index returns 5% and the tracking error is 2%, you could be losing out on 40% of your expected return.
Why Expense ratio Matters
One of the biggest selling points for ETFs is their low fees. In the past, it was common for mutual funds to charge annual management fees of well over 1%, but nowadays ETF investors can get away with fees as low as 0.1% – a 90% decline in fees. In fact, some funds don’t even charge a management fee.
The reality is that any expense ratio below 0.15% can be considered cheap. As long as the expense ratio is below that level, cheaper is not necessarily better. If you are deciding between two funds and one charges 0.07% while the other charges 0.12%, other factors are probably more important than the fee.
The situation changes when you start considering more specialized funds. Sector focused funds charge 0.15 to 0.3%, while industry-focused funds charge in the region of 0.3% to 0.6%. More sophisticated funds like smart beta, leveraged and inverse funds charge up to 1.5%, and actively managed funds can charge as much as 5%!
For any ETF with an expense ratio greater than 0.2%, you will need to weigh up the fee against the supposed advantages of investing in the fund. A higher fee may well be justified, but you also need to be sure the fund will do what it’s supposed to do. This is where past performance may be of some value – not necessarily in terms of returns, but volatility, dividend yield, and other metrics.
Your anticipated holding period is also relevant when considering fees. If the holding period is short, you will effectively be paying a tiny fraction of the annual management fee – but you will be paying commission more often.
Additional Fees to Calculate
In theory, the expense ratio of an ETF includes all management fees and the operational costs of managing a fund. There are however certain costs that are not included. The largest of these are the transaction fees incurred by the fund when securities are bought and sold, including commissions, the bid-offer spread, and costs built into derivative products.
These costs will be reflected in the tracking error, but typically the more sophisticated the fund is, the higher these costs will be.
Liquidity of ETFs and AUM
The liquidity of an ETF and the liquidity of the securities it holds affect the entry and exit price for ETF investors. If the bid and offer price is close to the fund’s NAV, you will incur little additional expense when you buy or sell shares in the ETF. So, funds with tight spreads are a lot cheaper to own.
The bid-offer spread for an ETF is maintained by market makers who also create and redeem units to satisfy demand. Two factors affect their ability to maintain a tight spread. Firstly, larger funds have more ongoing supply and demand from other investors which makes it easier to maintain a tight spread. As a rule of thumb, a fund should ideally have assets of $100 million or more, but definitely not less than $10 million.
The second factor is the liquidity of the securities in the fund. Market makers can also create and redeem units to maintain a liquid market. When they do so, they buy and sell the securities for the fund. If the bid-offer spread for those securities is very wide, the cost will translate into a wider spread for the ETF itself.
Issuer and fund structure
Exchange traded funds exist as separate entities from their issuers, and investors are well protected by the legislation under which they are regulated. However, an issuer can still manage the fund inefficiently, which will lead to higher transaction costs. For this reason, you should consider the track record of the issuer.
The global ETF giants are iShares/Blackrock, Vanguard, State Street/SPDR, and Invesco. Other prominent issuers are XTrackers, Schwab, First Trust, VanEck, Lyxor, WisdomTree, and ProShares. In addition, large global banks like JP Morgan and UBS issue ETFs. These companies all have good track records, but if you are considering a fund from another issuer, you may want to do some research on the company and its reputation.
If a fund you are considering is an ETN (exchange traded note) the creditworthiness and financial health of the issuer is also worth investigating.
It’s always worth remembering your goals when choosing ETFs. Leveraged and inverse ETFs are for the most part trading tools. If your objective is to trade the market actively, then these may be appropriate tools. But, if your objective is to build a long-term investment portfolio, then your priority should be cost-effective ETFs that track indexes that will compound over the long term. The trap that investors often fall into is chasing ‘hot’ sectors and industries or investing in funds with strong historical performance. For long term investors, an index with exposure to lots of sectors and to profitable companies with a proven business model, will be better placed to weather the storms that will inevitably occur along the way.
Leveraged ETFs are exchange-traded funds that are structured to amplify the daily returns of an underlying index. They combine the convenience of ETFs with the leverage typically associated with more complex financial products.
How leverage in ETFs Works
Leverage, also known as gearing, is used by traders and investors to increase potential returns. This is done by increasing the exposure of a portfolio to an asset. If 100% of a portfolio is invested in an asset, and the asset’s value increases 3% in a day, then the portfolio’s value also increases 3%.
Now, if 200% of the value of the portfolio was invested in the same asset, it would generate a return equal to 6% of the portfolio’s value. To open a position worth more than the value of a portfolio, debt, margin, or derivatives are used. All three methods essentially entail borrowing capital while using existing capital as collateral.
If a fund has exposure worth twice its assets, it is said to be 2X or 200% leveraged. Financial products can be leveraged anywhere from 1X to 50X, but leveraged ETF gearing typically only ranges from 1.25X to 5X.
Standard ETFs vs Leveraged ETFs
ETFs are portfolios of securities that are themselves listed like ordinary shares. The vast majority of ETFs invest in a basket of securities to track the performance of index. The basket is therefore structured to mirror the index.
Leveraged ETFs are quite different, and don’t simply hold a portfolio of securities. To amplify returns, leveraged ETFs either use derivatives, or debt to increase the exposure to the index. Using debt and derivatives introduces new costs and risks to the fund.
Standard ETFs are predominantly passive investing vehicles. They make passive, long term investing accessible to investors with little investing knowledge or capital. Leveraged ETFs are a departure from this type of investing and are more suitable for active trading and hedging.
Daily returns vs long term returns
An important aspect of leveraged ETFs is the way they track an index. In order to generate returns equal to a specific multiplier of the index return, the fund must be rebalanced each day. But this means the returns will only be equal, or very close, to the multiplier of the index returns each day. Over longer periods, the amplified returns will compound.
Let’s consider as an example an ETF that is designed to return three times the return of the S&P500 index. If the index is up 1% on a given day, the fund should be up 3% for the day. Likewise, if the index is down 2% on a given day, the fund will be down around 6%. But, if the index is up 10% in a given month or year, the fund is unlikely to be up 30% for the same period. This is a result of the compounding of leveraged returns.
During strong bull markets, positive returns will compound, and the total return may be greater than expected. However, during bear markets and volatile periods, the return is likely to be significantly worse than expected.
Leveraged ETF costs
The expense ratio of an ETF reflects the management fees and operational costs for the fund. It is expressed as a percentage of the fund’s NAV that is paid by shareholders each year. The fee is spread across the entire year by adjusting the NAV a tiny amount each day.
The expense ratio for leveraged funds is substantially higher than it is for standard ETFs. Most funds that track the S&P500 charge less than 0.1%, while leveraged versions of the same fund charge around 1%. The higher fees reflect borrowing costs and the fact that the fund needs to be rebalanced each day.
In addition, there may be other ‘hidden costs’ that are priced into the derivative contracts used to increase exposure. These costs are not deducted from the NAV but may act as a drag on performance.
Alternatives to leveraged ETFs
There are several other ways to leverage your exposure to an index, each with its own advantages and drawbacks:
- A margined account is a stock trading account that gives you buying power worth more than the capital in your account.
- You can use your portfolio, or other assets, as collateral to borrow capital to increase buying power.
- You can use derivatives like futures, CFDs (contracts for difference) or options.
Some of these alternatives are cheaper than leveraged ETFs but cannot be traded with a regular stock trading account.
Examples of Leveraged ETFs
Not all ETF issuers manage leveraged funds. In fact, just three companies issue most of the ETFs on the market – ProShares, iPath, and Direxion.
The ProShares UltraPro QQQ fund (TQQQ) is designed to return 3X the daily returns of the Nasdaq 100 composite index. As of September 2020, this was the largest US-listed leveraged fund with assets under management of $8.9 billion. This fund has an expense ratio of 0.95%.
The largest fund that generates leveraged returns based in the S&P500 index is the ProShares Ultra S&P ETF (SSO) This fund generates 2X the daily returns of the index and has an expense ratio of 0.92%.
The ProShares UltraShort S&P 500 fund (SDS) is a popular vehicle for shorting the S&P index. It generates 2X the inverse return of the index and has an expense ratio of 0.89%. You can learn more about inverse ETFs here.
Bond investors can speculate on interest rate changes with leveraged and inverse leveraged ETFs. The Direxion Daily 20-Year Treasury Bull (TMF) seeks to return 3X the return of the NYSE 20 Year Plus Treasury Bond Index. The Direxion Daily 20-Year Treasury Bear ETF (TMV) returns 3X the inverse of returns from the same index. These funds charge 1.09 and 1.02% respectively.
Advantages of leveraged ETFs
• Leveraged ETFs are the easiest way to increase exposure to an index using a regular trading account. You do not need a margin account or a derivative trading account to trade them.
• They can be used to speculate on short term price movements.
• Leveraged inverse ETFs can be used to hedge market exposure over short periods of time.
Disadvantages of Leveraged ETFs
• Negative returns can compound very quickly. This makes leveraged ETFs very risky over periods longer than a day or two.
• Capital gains realized over short periods of time may be subject to higher tax rates.
• The expense ratios of leveraged ETFs are significantly higher than they are for standard ETFs.
Leveraged ETFs are useful for short term speculation and hedging. Although they are more expensive than regular funds, the costs can be justified over short periods. However, they do need to be treated with caution as they come with significant risks.
What are Inverse ETFs?
Inverse ETFs are exchange traded funds designed to return the inverse of the daily return for an index. In other words, when the index loses value, the fund gains value – and vice versa, if the index gains value the fund will lose value.
Inverse ETFs, also known as short ETFs or bear ETFs, are designed to capture the inverse daily returns, rather than inverse long-term returns. They can be used to hedge a portfolio for short periods of time or to speculate on falling prices.
ETFs vs ETNs
Exchange traded funds (ETFs) and exchange traded notes (ETNs) are very similar products. They are often used interchangeably and serve the same function. However, there is an important distinction. Some of the inverse products that are widely traded are actually ETNs, so it is worth understanding the difference.
An ETF is a trust which owns a portfolio of assets. ETFs are designed to track an index, but their value is actually determined by the value of the assets held by the trust. This means there may be a small difference between the performance of the fund and the index it tracks, known as tracking error.
By contrast, an ETN, is actually a type of unsecured debt security. It has a maturity date, at which point the issuer will pay the holder the initial capital plus or minus the return of an index. An ETN does not represent ownership of any assets. Instead, the product is backed by the issuer.
ETNs are well suited to situations where a traditional portfolio of assets is difficult or expensive to create. On the other hand, they introduce counterparty risk to the product.
Leveraged inverse ETFs
Many of the most widely traded inverse ETFs provide leverage in addition to inverse returns. In other words, a 3X inverse ETF would rise 3 percent in value if the index fell 1%.
This is a useful attribute as it reduces the additional capital required to hedge a portfolio. Let’s say you have long positions worth $100,000. To hedge this portfolio by buying an unleveraged fund, you would need another $100,000. If you instead buy a leveraged inverse ETF with 3X leverage, you will only need $33,000.
We have covered leveraged ETFs in more detail here.
Alternative ways to short the market
Whether you want to hedge a portfolio of long positions, or you want to speculate on an index declining, inverse ETFs are one of the easiest methods available to the average investor. But there are a few other approaches worth knowing about.
Short selling shares entails borrowing shares from another investor (for which a fee is paid) and then selling those shares. When the shares are repurchased, they are returned to the lender. Short selling shares requires a special type of trading account.
You can also short sell derivatives like futures contracts or CFDs (contracts for difference). This is more straightforward as no borrowing is involved – however, you will need a derivative trading account.
Finally, you can buy put options on the asset you want to hedge. A put option gives you the right to sell the asset at a specific price. If the price of the asset does fall, you can either sell the asset at the higher price or simply sell the option which will have gained in value. Options trading also requires a derivative trading account.
Examples of inverse ETFs
The universe of inverse ETFs is dominated by a handful of issuers, with ProShares and Direxion accounting for most US-listed funds.
The largest inverse fund is the ProShares Short S&P 500 ETF (SH). This product is designed to return the inverse daily return for the S&P500 index and has an expense ratio of 0.89%.
Investors wanting to short an index of small-cap stocks can buy the ProShares Short Russell 2000 fund (RWM). This fund is structured to return the inverse daily returns for the well known Russell 2000 small-cap index.
The ProShares UltraPro Short ETF (SQQQ) is a useful product for shorting the Nasdaq 100 with 3X leverage. A similar fund with more focus is the MicroSectors FANG+ Index 3X Inverse Leveraged ETN (FNGD) which aims to return three times the inverse return of an index of 10 large, widely traded tech stocks. The index includes the popular FANG stocks, Facebook, Apple, Netflix, and Google.
Inverse ETFs are also available for other sectors and industries. For example, the ProShares UltraShort Real Estate fund (SRS) is based on the Dow Jones U.S. Real Estate Index and employs 2X leverage.
Bond investors wanting to hedge exposure or speculate on rising rates can buy the Ultrashort Barclays 20+ Year Treasury ETF (TBT). This fund focuses on longer-dated bonds and is 2X leveraged.
Similar ETFs can be used to hedge the prices of commodities like oil, gas, silver, and gold. The ProShares UltraShort Bloomberg Crude Oil fund (SCO) is the most popular fund in this category. It is 2X leveraged and the expense ratio is 0.95%.
A slightly different type of inverse ETF is the AdvisorShares Ranger Equity Bear ETF (HDGE). This fund is actively managed using quantitative trading strategies – however it comes at a cost of 3.12% a year.
Advantages of Inverse ETFs
- Inverse ETFs are very useful for reducing risk ahead of important economic releases and announcements.
- Inverse ETFs can also be used to profit from declines in most liquid markets and indexes.
- ETFs are the easiest way to open a short position as you do not need to borrow shares or open a derivative trading account.
Disadvantages of Inverse ETFs
- Inverse ETFs can expose your portfolio to many of the same risks as leveraged ETFs. Negative returns can compound very quickly, eroding the NAV of an ETF in the process.
- Positions need to be carefully managed and overnight positions should be limited. If a reversal occurs after the market closes, you will not be able to close your position until the market opens the following day.
- Inverse ETFs have significantly higher management fees than regular ETFs.
Like leveraged ETFs, inverse ETFs are useful for short term speculation and hedging. But they should also be approached with caution as they are more sophisticated than regular ETFs, and introduce new risks to the investing process.