In the previous post of the Investing series, we talked about mutual funds. They are a great tool for investment. And especially passive funds with very low fees, thanks to index investing.
This is all great, but the problem with mutual funds is their availability. If you are lucky, you have access to Vanguard. And you can directly invest in their low fees mutual funds. There are other like Vanguard, but they are the most famous ;) If you are not lucky, for instance, if you live in Switzerland, you don’t have any easy access to good mutual funds. I can bet that your bank does not offer cheap passive funds. At least mine doesn’t! Here comes Exchange Traded Funds!
Exchanged Traded Funds (ETFs)
We talked about what was a mutual fund in the previous article. It’s 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 can be your bank. But this can also be the manager of the fund, such as Vanguard. But in Switzerland, we don’t have access to any good mutual funds. They 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, DEGIRO, 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 cost and active funds rarely beat the market. Therefore, we will focus again on index ETFs.
You can buy a share of an ETF 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. Hopefully with a profit. And you should hold ETFs for long. If you trade ETFs for a quick, you are a trader and not a long-term investor. I’m going to focus on long-term investment here. That means hold for as long as possible.
Now, if you know how a stock is priced, you may wonder how Exchange Traded Funds can reflect the price of the index ? This 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’s enough to know that this will allow you to always trade the ETFs as if you were buying into the index. I will try to talk more about ETF arbitrage in a future post. But you really don’t need a details now ;) It’s enough to know that there can some variations due to stock market transactions. But in the end, the ETF price should mostly reflect the price of the index.
Important properties of Exchange Traded Funds
The first thing you want to do when you choose an index ETF is to choose the index. But then, you’ll be amazed by the number of funds for the same index. There are several important properties when choosing between different ETFs. Some of the 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. In fact, it’s the only factor of performance that you can really control. If two funds have the same index but different cost, the one with the lowest cost will return the most. There can be large difference in cost between different ETF for the same index. And you will find that ETFs have generally lower TER than similar mutual funds. But it’s 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 less likely to bankrupt. But it’s no guarantee of course. And finally, they are generally better at replicating the index. I will go in details 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. If you have a small fund with a low volume of transactions, there may be a spread. In that cases, you may have to buy higher than the market price or sell below the market price. Therefore, it’s generally good to select large funds with large volume of transactions.
Accumulating vs Distributing
Finally, there is a last important property of Exchange Trade Funds. It’s about the use of dividends by the fund. Some of funds are using the dividend to buy new shares. This is called an accumulating strategy. In the 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 were owning shares of all the companies in the index. I prefer distributing funds. But it’s 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.
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 don’t need to go through your bank or any financial institution. I’m using DEGIRO as my broker. It is generally very simple to buy shares of ETF. As an example, I wrote an example on how to buy an ETF using DEGIRO.
I’m only using ETF as investment instrument. For an example, you can take a look at my ETF portfolio. I’m not a financial advisor, this 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 ;)
I don’t yet know what the next post in the Investing series will be. I have several ideas. I want to write about Index Replication in more details. I also want to write about ETF arbitrage. What would you like me to write about ?
Are you using ETFs ? Do you prefer ETFs or mutual funds ?