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Mutual funds are an excellent way to invest. Instead of investing in single stocks, you can invest in many stocks at once. Thanks to index investing, passive funds with very low fees are especially interesting.
Unfortunately, mutual funds are not accessible to everyone. It is where Exchange Traded Funds (ETFs) come into play!
Banks and fund providers such as Vanguard or Blackrock provide Mutual Funds. 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.
If you are not lucky, you cannot access good mutual funds easily. This is, unfortunately, the case in Switzerland. I can bet that your Swiss bank does not offer cheap passive funds. Instead, they will probably provide you with expensive active funds. It is the main reason Exchange Traded Funds (ETFs) are an excellent investment tool!
In this article, we learn all about Exchange Traded Funds! I invest directly in ETFs!
Exchange Traded Funds (ETFs)
A mutual fund is a managed collection of financial instruments. It can contain stocks, 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 fund manager, such as Vanguard. But in Switzerland, we cannot access any good mutual funds. Vanguard does not provide access to its funds to Swiss investors. All available mutual funds are costly. So we need another option.
Exchange Traded Funds (ETFs) are funds traded on the stock market. They are available to everybody with access to a broker. My current broker, Interactive Brokers, offers access to a long list of them. As will most brokers. For all the large 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 other kinds of ETFs. The most common type of ETF is a Stocks ETF. But there are also Bonds ETFs and Currency ETFs. Bond funds have some interesting properties, especially regarding their prices.
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 must go through the 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. Go to your broker, search for the ETF you want to invest in, and buy it at the current price. Then, 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 the long term. If you trade ETFs for a quick buck, you are a trader, not a long-term investor. So I will focus on long-term investment here. That means hold for as long as possible.
Another significant difference between ETFs and Mutual Funds is when you can trade them. Since an ETF is on the stock exchange, you can trade it when 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 the two brokers I have used:
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 an excellent question.
The short answer is that you do not have to worry about that. But the complete answer is complicated. ETF arbitrage is used to minimize the difference between the price of the ETFs and the index. For now, knowing that this will allow you to always trade the ETFs as if you were buying into the index is enough.
It is enough to know that there can be variations due to stock market transactions. But in the end, the ETF price should mostly reflect the index’s price. Some counterparties will ensure that shares are sold and bought when necessary to keep the price in check.
If you want to know 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 choosing 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 for the same index. There are several important properties when choosing between different Exchange Traded Funds. Most of them are the same as when you choose between mutual funds. But some of them are different.
Total Expense Ratio (TER)
First, pay attention to the fund’s Total Expense Ratio (TER).
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 fees, the one with the lowest fee will return the most. There can be large differences in fees 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.
You should not underestimate the impact of investing fees.
The second important characteristic is the size of the fund. By size, I mean the total amount of money the fund manages.
You should prefer large funds over small funds. They have several advantages. First, the bigger the fund, the lower the ask/bid spread. The following section will cover this in detail. Second, large funds also generally have lower risks. Third, they are less likely to bankrupt. And finally, they are usually better at replicating the index.
The ask/bid spread is simply the difference between the prices sellers ask for and buyers’ prices.
Ideally, you want the spread to be as low as possible. However, this mainly depends on the fund size and the trading volume. Generally, the more buyers and sellers there are the lower the spread.
There may be a large spread if you have a small fund with a low volume of transactions. You may have to buy higher than the market price or sell below the market price in those cases. Therefore, selecting large funds with a large volume of transactions is generally acceptable.
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 fund’s value will increase 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 similarly 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 consider when choosing between Exchange Traded Funds. Fortunately, this is not something you often do.
But it is something important. You do not want to change ETFs often. Ideally, you will choose an ETF and invest long-term into that fund. Changing ETF is not difficult, but it is not free either.
If you want more details, I wrote a full guide on choosing an Exchange Traded Fund to invest in.
Exchange Traded Funds vs Mutual Funds
Now, you may wonder how 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. And it is the same for Blackrock, another huge investment company.
In this blog, I primarily speak about ETFs. And I only invest in ETFs. But this does not mean ETFs are better than mutual funds! In Switzerland, we do not have access to good mutual funds! For example, Vanguard does not offer access to 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 (for instance, because of a circuit breaker).
- There is no bid/ask spread with mutual funds, but there can be a significant spread in ETFs.
So, overall, deciding which instrument you prefer is up to you. But remember to focus on passive funds.
If I had access to Vanguard mutual funds in the United States, I would invest directly through them.
What is an Exchange-Traded Fund (ETF)?
An Exchange Traded Fund (ETF) is a mutual fund traded on the stock market. It can be traded at any time during stock market opening hours. It is traded using a broker account, on the stock exchange.
What is the difference between an ETF and a mutual fund?
A mutual fund can be traded only once a day, while an Exchange Traded Fund can be traded any time during market opening hours. You only need a broker to access an ETF. You do not need to go through a mutual fund company.
An Exchange Traded Fund (ETF) is a fund traded on the stock market. It has almost the same properties as a mutual fund. But the availability is better since you only need 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. It is the best broker for my needs. But there are many brokers out there. It is generally straightforward to buy shares of ETF. As an example, I wrote a guide on how to buy an ETF on Interactive Brokers.
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. Ultimately, only you have to decide what you want to do with your money!
There is one essential thing about ETFs. Exchange-Traded Funds are 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. Instead, you should only use them as long-term investments like a mutual fund.
I speak primarily about ETFs on this blog because we do not have access to good mutual funds in Switzerland. Therefore, we need ETFs to invest with Vanguard, for instance. But there is nothing wrong with mutual funds! If you have access to them, invest in their mutual funds! I wish I could do the same in Switzerland!
To learn more about Exchange Traded Funds, read about the different ways an ETF can replicate an index. Or you can learn how ETFs are kept synchronized with the index price.
Are you using ETFs? Do you prefer ETFs or mutual funds?
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