ETF vs. Index Fund - Why I Prefer Index Fund
In the world of investing, the debate between ETFs and index funds is a heated one. Though I’ll be honest, from a big picture perspective, you honestly can’t go wrong with either one. If you are saving and investing, you are already winning. But since I primarily invest with index funds, in this post I do want to make the argument that if you are a long-term buy and hold investor, you don’t need ETFs in your portfolio.
Index Fund 101
First let’s talk about index funds. Index funds are actually a type of mutual funds. At the basic level, there are two types of mutual funds. Actively managed funds and passively managed funds. In an actively managed fund, there is an active fund manager who selects specific stocks or bonds based on analysis. This could be based on technical analysis or fundamental analysis. Passively managed fund, which is an index fund, simply tracks an index. Attempting to match the return of the segment of the market that it is indexing
An S&P 500 Index Fund matches the 500 largest publicly traded companies in the United States.
A Total Stock Market Index Fund replicates all the publicly traded companies in the United States.
A Total International Index replicates a broad cross-section of thousands of reputable international stocks.
With a small management fee for each fund, ranging from 0.04% to 0.11%, you can be invested in an index fund within minutes. Before the introduction of mutual funds and index funds, if you as an investor wanted diversification in your portfolio, you essentially needed to create it on your own. You had to research individual companies and purchase enough stocks to create your ideal diversified portfolio. Frankly, it was very time consuming and unrealistic for most people. Most often individuals would hire brokers to do this manual work, which just added more cost. And because of this reason, indexing in many expert’s opinions is really one of the best ways to invest. Let’s talk about a few of its key characteristics.
1 - Higher Diversification
The first as I mentioned already is its diversification. Index funds by nature are highly diversified and therefore less risky. Diversification is the key to reducing investment risk. The fastest way to get rich overnight is to own the next Netflix. But the fastest way to lose all your money is to own the next Blockbusters. To know what companies will do well or not do well is nearly impossible. However, you don’t need to have a magic ball in order to get healthy returns on your investment. If you buy a fund that tracks the S&P 500 or Total Stock Market Index, your investment is highly diversified and its performance will match that of the companies that the fund is indexing.
2 - Low Operating Cost
The second characteristic of an Index fund is its low operating cost. Actively managed mutual funds are known to charge anywhere between 1 to 2 percent expense ratios. This means that between 1 to 2 percent of your investment is deducted each year to pay the fund manager to run the fund. On a $100,000 portfolio, that comes out to $1K to $2K annually.
By contrast, index funds are much cheaper given no person is actually managing the fund’s performance. There isn’t a person deciding which funds to buy or sell or when to buy or sell them. The fund simply replicates the index. As a result, most index funds have an expense ratio well under 0.1%. VTSAX and VFIAX, Vanguard’s Total Stock Market Index Fund and Vanguard's S&P 500 Index Fund have respective expense ratios of 0.04%.
On a $100,000 portfolio, this comes out to $40 annually. I’ll take a $40 expense over $2,000 any day. And the real power of low operating cost really comes to play when you incorporate compounding into the formula. These expense ratios can net you or cost you hundreds of thousands of dollars over a period of 10 to 20 years. Cost matters and passively managed index funds have rock bottom costs.
3 - No Investment Manager
The third, and one of my favorite characteristics of index funds is that there really isn’t a need to hire an investment manager to monitor your portfolio. I firmly believe that with enough right information, any of you can effectively manage your own portfolio. When you have an investment manager, they take a huge chunk of your portfolio to manage your money for you. This is real money that is going into someone else’s pocket instead of staying and compounding in your account.
Some argue that there are really good investment managers whose performance is worth the cost. Peter Lynch, managed the Fidelity Magellian fund from 1978 to 1990 and posted an average annual return of 29%. However, such individuals are so rare that some investment scholars attribute their consistent performance to luck rather than skill.
Just like stocks, many of yesterday’s superstar managers can quickly turn to today’s underperformers. And how can you effectively identify who tomorrow’s superstar will be? This unfortunately is a futile pursuit. The bottom line is that with index funds, who’s managing the fund is not an issue. Index funds only track the index. Nothing more. Nothing less.
4 - Net Asset Value
The fourth characteristic of an index fund is that when you purchase a share of an index fund. Or even an actively managed mutual fund, you are always paying what is called the Net Asset Value. The NAV. The NAV represents the per share value of all the stocks that the fund owns.
For example, currently The NAV for Vanguard's total stock market index fund, the VTSAX is around $100 per share. The NAV for Vanguard 500 Index Fund, VFIAX is around $400 per share. And unlike a stock price or ETF that fluctuates through the trading day, an index fund’s NAV is adjusted once after the market closes. So technically, when we submit a buy or sell order for a share of an index fund, we won’t know the actual price until after the market closes.
ETF 101
Alright, let’s talk about ETFs. Exchange Traded Funds. Big picture, ETFs are virtually identical to index funds in a lot of ways. Just like index funds, it provides a low cost way to achieve great diversification. VTI, Vanguard Total Stock Market Index Fund ETF tracks total stock market index exactly like the VTSAX. VOO, Vanguard 500 Index Fund ETF tracks the S&P 500 stock market index exactly like the VFIAX. And just like index funds, they are quite affordable with expense ratios of 0.03%. Index funds like VTSAX and VFIAX if you remember have an expense ratio of 0.04%, so ETFs are actually 0.01% cheaper.
However, there are few significant differences that need to be highlighted. Exchange Traded Funds, as its name implies, has the ability to trade like stocks on an exchange. Some investors wanted the ability to trade index funds in ways similar to trading a stock. ETFs was their solution. It’s an ideal blend between index funds and individual stocks.
Just like buying or selling a stock, the price of the Vanguard Total Market Index ETF fluctuates throughout the day when the market is open. That is why when you are looking at the purchase price of VOO vs VTSAX, you see the opening price, previous close price and the day range. You also see bids and ask spreads just like what you would see for an individual stock.
If I wanted to buy VOO, I know pretty much what price I am going to get within a range of a few pennies. What this means is that an ETF gives an investor the ability to time their purchase, short it or buy and sell options on it. All the things you can do with individual stocks. Index funds don't come with all these bells and whistles.
Why I Prefer Index Fund
At a glance, ETFs seem like a better deal. You get all the bells and whistles even though you may not think you’ll need it right away. Let’s say that you go to a car dealership to buy a simple car that will take you from point A to point B. But then you see another car, at the same price, that can do all the things that the first car can do, but with more bells and whistles. What would you pick? Probably the car with the bells and whistles right? But let me share with you a few reasons why ETFs may not be the best choice if you are a long term buy and hold investor.
1 - No Need For Bells & Whistles
First, long term buy and hold investors don’t need all the additional features that ETFs offer. Buy and hold investors who plan on buying investments regularly and plan on holding it for a long period of time, don’t try to time the market. Buy and hold long term investors wouldn’t think about trying to short an ETF. Or buy or sell calls. Or put options on an ETF. Simplicity is the name of the game for index investors and a good low cost index fund is the best at that.
2 - No Automatic Investment
Second reason is the fact that you can’t set up automatic investments with ETFs. Function that is crucial to buy and hold investors. And this is due to a concept called “Fractional Shares.” Or more specifically if you can purchase the fund in fractional shares. It sounds fancy, but if you know basic algebra you get the concept. It means just what it sounds like. When you have the ability to purchase a fund as fractional shares, you have the ability to buy a “fraction” of the share. You aren’t locked into needing to buy the whole share.
For example, let’s say VTSAX is trading at $100 per share today. You might only have $50 to invest, so you can just buy a “fraction” of that $100 / share. Essentially half a share with that $50. Now, VTSAX, the index fund, allows you to purchase the fund as fractional shares. However, VTI, the ETF equivalent, does not. With VTSAX, it doesn’t matter how much you have, you can invest that full amount into the fund regardless if the money you have is a $1 or a $1,000.
VTI on the other hand, because it does not allow fractional shares, you in essence might have money left over or not be able to afford the share that day. Almost like needing exact change at the grocery register. One thing I want to call out is that this is Vanguard specific. Other firms, like Fidelity, allow for fractional shares for its ETFs. We will need to wait and see if this trend will be more widely implemented across all investment firms. But for now, if you are invested in Vanguard like me, just know that you can’t make fractional share purchases with VTI.
And this is the primary reason why you can't make automatic investments or withdrawals into or out of ETFs. This makes sense given you can’t do fractional share purchases of VTI. You’ll need exact change each time so you’ll need to manually make purchases. For index funds on the other hand, you can set up automatic investments and withdrawals into and out of any of Vanguard’s mutual funds based on your preferences.
3 - Minimum
But there is a good argument that many people make as regards to the ETF over the index fund. And that is the minimum investment. Index funds, most often have a minimum amount of cash in order to invest. In the case of Vanguard Total Market Index Fund it is $3,000. VTSAX equivalent ETF like VTI has no minimum. You just need enough to purchase one single share.
In this category, an ETF like VTI has a big advantage. Because they are traded like stocks, there is no minimum investment. You just need enough to purchase a single share. However, my personal opinion is that one should save up the $3,000 to invest in VTSAX. While you can convert a VTSAX to a VTI pretty easily, the other way isn’t so straightforward. You can’t convert VTI to VTSAX. You will need to sell VTI which will trigger a capital gains event which you will need to pay taxes on.
Conclusion
Alright, despite what my personal preference is, many people still prefer an ETF over Index Funds. This is because of the reasons I mentioned earlier in this post; timing of share price, minimum and expense ratio. I completely respect that. They are all very important and valid reasons. Because again, in the big scheme of things, if you are saving and investing consistently, you are already winning. Index fund vs ETF is just personal preference. You can’t go wrong with either one.
But I want to share with you one final reason why I personally prefer Index Funds over ETFS. And that is because it saves me time. I like the idea of automating my buy order so that the trade is executed regularly, every month without me even realizing that it’s happening. Whether I’m working or on a vacation trip with my family.
Compared to having to find time on Monday while the market is open to put in a buy order. Calculate how many shares I can buy based on the share price, watch it to make sure the order executes and get annoyed by the fact that there are few dollars left over that can’t be invested. Yes, does ETF allow for specific share prices? Does it have a lower expense ratio? Does it allow me to get into with less than $3,000? Of course. But for me, I prefer to spend the extra time making more money to invest in the market and with my family.
