In much of the previous articles we were comparing mutual funds to ETFs, the merits of actively managed mutual funds are compared to the passively managed ETFs. In some ways, it is like comparing apple to oranges. They have entirely different characteristics. If a passive approach is desired, an investor should then consider how best to implement it - by using index funds or exchange traded funds.
Index funds have been obtainable in the U.S. since the 1970s; ETFs were first traded in the U.S. in 1993. Even though the number of index funds and ETFs are close, ETFs cover about five times as many indexes. Some of the newer ETFs track some indexes that are more suitable for an ETF structure than for an index fund. Therefore an investor might only be able to track an index by using ETFs because there are no index funds obtainable that can track that same index
ETFs and index funds each present pros and cons for organization the costs of the fundamental assets. In some cases the dissimilarity in fees might favor one over the other. Investors can buy no-load index funds without incurring any transaction costs. Investors buying ETFs have to pay brokerage commissions.
The structure of an ETF results in lesser taxes versus the equivalent index fund. This is because the way in which ETFs are shaped and redeemed eliminates the need to sell securities. With index funds, securities are bought and sold even though with lower turnover than a typical actively manage fund. This deal will generate capital gains that have to be spread to the unit holders.
The character of ETFs requires them to collect dividends or interest received from the original securities until it is dispersed to shareholders at the end of each quarter. Index funds invest their dividends or interest income straight away.
An investor with a portfolio of index funds or ETFs occasionally rebalances the portfolio selling some of the positions and purchasing others. A portfolio containing ETFs incurs commissions by buying and selling the ETFs. Since the investor classically trades in board lots getting the exact weightings of each ETF preferred is practically impossible. This is particularly true for small portfolios. With index funds an investor can achieve exact asset allocation weightings because the investor can purchase fractional units. No-load funds have no transaction costs.
The technique of using ETFs for dollar-cost averaging spending a fixed amount at regular intervals on a portfolio is normally impractical. The commission costs and the extra cost involved in buying odd-lot shares make this strategy very expensive to implement. Mutual funds are a more suitable investment vehicle for dollar-cost averaging.
A lack of liquidity on some ETFs resulting in an increase in the bid-ask spread adds to the cost of trading ETFs. The less popular ETFs are not likely to have the same arbitrage interest of other ETFs, resulting in a potentially larger variation between market prices and net asset value (NAV). Investors in index funds can always get the NAV at the end of the day.
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