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In our Investing Guide For Beginners series, we already talked about mutual funds. Instead of investing in single stocks, you can invest in many stocks at once. Mutual Funds are a great tool for investment. We are especially interested in passive funds with very low fees, thanks to index investing! Unfortunately, mutual funds are not accessible to everyone. It is where Exchange Traded Funds (ETFs) come into play!
The problem with mutual funds is their availability. They are provided by banks and fund providers such as Vanguard. If you are lucky, you have access to Vanguard via your bank. Or you can directly invest in Vanguard funds. That means you can directly invest in their low fees mutual funds. There are others like Vanguard, but they are the most famous!
If you are not lucky, for instance, if you live in Switzerland, you do not have any easy access to good mutual funds. I can bet that your Swiss bank does not offer cheap passive funds. They will probably offer you expensive active funds. At least mine does not! It is the main reason why Exchange Traded Funds (ETFs) are a very good investment tool!
In this post, we are going to learn all about Exchange Traded Funds!
Exchanged Traded Funds (ETFs)
We talked about what was a mutual fund in the previous article. It is a managed collection of financial instruments. It can contain stocks, or bonds, or both. By buying into the fund, you are essentially buying a part of all the financial instruments the fund invests in.
But a mutual fund is only available through a financial institution. This institution can be your bank. But this can also be the manager of the fund, such as Vanguard. But in Switzerland, we do not have access to any good mutual funds. Vanguard does not provide access to its funds to Swiss investors. All available mutual funds are all very expensive. So we need another option.
Exchange Traded Funds (ETFs) are funds traded on the stock market. They are available to all as long as you have access to a broker. My current broker, Interactive Brokers, offers access to a very long list of them. As will most brokers. For all the big mutual funds today, there is an ETF alternative. Most of the ETFs are passive indexing funds. However, there are also active ETFs. We saw last time that index funds have lower costs, and active funds rarely beat the market. Therefore, we will focus again on index ETFs.
Such as there are mutual funds for different financial instruments, there are also different kinds of ETFs. The most common kind of ETF is Stocks ETFs. But there are also Bonds ETFs and Currency ETFs.
How to invest in ETFs?
The main difference between mutual funds and Exchange Traded Funds is how to buy and sell them. For a mutual fund, you will have to go through the mutual fund provider and deposit money into one of their mutual funds.
On the other hand, Exchange Traded Funds are exchanged on the stock market.
You can buy a share of an Exchange Traded Fund as you buy a share of a company. Simply go to your broker, search for the ETF that you want to invest in, and buy it at the current price. If you need the money, you can sell the shares and get some money back, once again, from your broker.
Hopefully, you will sell for a profit. And you should hold ETFs for long. If you trade ETFs for a quick buck, you are a trader and not a long-term investor. I am going to focus on long-term investment here. That means hold for as long as possible.
Another major difference between ETF and Mutual Funds is when you can trade them. Since an ETF is in the stock exchange, you can trade it at any time the exchange is open. On the other hand, a mutual fund can only be bought and sold once a day.
If you do not know how to start, you can read my guides about buying ETFs shares from my two favorite brokers:
Now, if you know how a stock is priced, you may wonder how Exchange Traded Funds can reflect the price of the index? It is a very good question.
And the complete answer is complicated. ETF arbitrage is used to minimize the difference between the price of the ETFs and the index. For now, it is enough to know that this will allow you always to trade the ETFs as if you were buying into the index.
It is enough to know that there can be some variations due to stock market transactions. But in the end, the ETF price should mostly reflect the price of the index. Some counterparties will ensure that shares are sold and bought when necessary to keep the price in check.
If you want to know all about ETF Arbitrage, I wrote a detailed guide on Exchange Traded Fund Arbitrage.
Important properties of Exchange Traded Funds
The first thing you want to do when you choose an index ETF is to choose the index you want to invest in. There are already many parameters to take into accounts.
But, once you have chosen a stock market index, you will be amazed by the number of funds there are for the same index. There are several important properties when choosing between different ETFs. Some of them are the same as when you choose between mutual funds. But some of them are different.
Total Expense Ratio (TER)
The first thing you need is to pay attention to the Total Expense Ratio (TER) of the fund.
As mentioned before, the cost is the most important factor. It is the only factor of performance that you can control. If two funds have the same index but different costs, the one with the lowest cost will return the most. There can be large differences in cost between different ETFs for the same index. And you will find that ETFs generally have lower TER than similar mutual funds. But it is not a very significant difference.
The second important characteristic is the size of the fund.
You should prefer large funds over small funds. They have several advantages. First, the bigger the fund, the lower the ask/bid spread will be. The next paragraph will go with this. Large funds also generally have lower risks. They are less likely to bankrupt. But it is no guarantee, of course. And finally, they are generally better at replicating the index. I will go in detail about replication in a later post.
The ask/bid spread is simply the difference between the price sellers ask for, and the price buyers ask for.
Ideally, you want the spread to be as low as possible. However, this mostly depends on the size of the fund and the trading volume. The more buyers and sellers there are, the lower the spread will be.
If you have a small fund with a low volume of transactions, there may be a spread. In those cases, you may have to buy higher than the market price or sell below the market price. Therefore, it is generally good to select large funds with a large volume of transactions.
Accumulating vs Distributing
Finally, there is one last important property of Exchange Traded Funds. Funds can be either accumulating or distributing.
It is about the use of dividends by the fund. Some of the funds are using the dividend to buy new shares. This strategy is called an accumulating strategy. In this case, the value of the fund will go up with the dividend since they have more shares.
The second strategy is simple. The dividends are distributed to the owner of the shares. You receive the dividends as if you owned shares of all the companies in the index. I prefer distributing funds. But it is a matter of personal taste. There is a lot of talk going on about taxes and accumulating vs distributing funds. But at least for Switzerland, you get taxed in the same way in the end. But it may depend on your country.
For more information, read this comparison of accumulating funds and distributing funds.
Choosing an ETF
As you can see, there are many things you can take into account when you are choosing between Exchange Traded Funds. Fortunately, this is not something you are going to do often.
But it is something important. You do not want to change ETF often. Ideally, you will change to choose an ETF and invest for the long-term into that fund. Changing is ETF is not difficult, but it is not free either.
If you want more details, I wrote a full guide on how to choose an Exchange Traded Fund to invest in.
Exchange Traded Funds vs Mutual Funds
Now, you may wonder what do you need to choose between an Exchange Traded Fund and a Mutual Fund.
Most big investment companies will offer both. For instance, Vanguard has both mutual funds and ETFs for each of their funds.
On this blog, I will mainly speak about ETFs. And I only invest in ETFs. But this does not mean ETFs are better than mutual funds! In Switzerland, we simply do not have access to mutual funds! Vanguard does not offer their mutual funds to Swiss investors. Therefore, we need to use ETFs.
If you have access to both mutual funds and ETFs, there are a few differences between both:
- ETFs require access to a broker account and are a bit more difficult to buy.
- ETFs are sometimes slightly cheaper than mutual funds, but the difference is not significant.
- ETFs can be traded at any time of the day (in the opening hours of the exchange). But mutual funds can only be sold and purchased once a day.
- Mutual funds can always be traded, while the stock exchange could be closed for some reasons, such as a circuit breaker.
- There is no bid/ask spread with mutual funds, but there can be significant spread in ETFs
So, overall, it is really up to you to decide which instrument you prefer. But remember of focus on passive funds.
An Exchange Traded Fund (ETF) is a fund that is traded on the stock market. It has almost the same properties as a mutual fund. But the availability is best since you only need to have access to the stock market. You do not need to go through your bank or any financial institution. You need a broker account, though.
I am using Interactive Brokers as my broker. I believe it is the best broker for my needs. But there are many brokers out there. It is generally very simple to buy shares of ETF. As an example, I wrote a guide on how to buy an ETF on Interactive Brokers and one on how to buy an ETF using DEGIRO.
I am only using ETF as a long-term investment instrument. For example, you can take a look at my ETF portfolio. I am not a financial advisor. It should only give you a rough idea of what can be done. In the end, only you can decide what you want to do with your money!
One thing is important with ETFs. They are really good for long-term investments. But you should not trade them a lot. It is not because they are available on the stock market that you should trade them daily. You should only use them as long-term investments like a mutual fund.
The main reason I speak mostly about ETFs on this blog is that, in Switzerland, we do not have access to good mutual funds. Therefore, we need ETFs to be able to invest with Vanguard, for instance. But there is nothing wrong with mutual funds!
To learn more about Exchange Traded Funds, read about the different ways an ETF can replicate an index. Or you can learn about how ETFs are kept synchronized with the price of the index.
Are you using ETFs? Do you prefer ETFs or mutual funds?