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Robert Abbott
Robert Abbott
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Indexing for Dummies: Comparing Mutual Funds & ETFs

How do the pros and cons of index mutual funds and index exchange-traded funds compare?

May 13, 2019 | About:

There are two ways to invest in index funds, and their advantages and disadvantages are discussed in chapter six of Russell Wild’s book, “Index Investing for Dummies.” Those two ways are mutual funds and exchange-traded funds (ETFs).

Of course, you might try to create your own index fund by buying one or more shares of every stock represented in a market or sub-market of interest. However, that would be very costly and time consuming, and in the end likely wouldn’t mirror the index you’re trying to track.

Mutual funds are the traditional vehicles, and while they have been around for some time, index mutual funds have only been widely available since the mid-1970s. That was when Jack Bogle and his Vanguard Group turned the investing world on its head by proclaiming that passive investing could (and usually would) outperform active investing.

In the 1990s, a new kid turned up on the block: ETFs. They were created in response to the growing interest in index investing, and rapidly emerged as a strong competitor to mutual funds. In an earlier chapter, Wild argued there wasn’t a great deal of difference between them as far as most passive investors were concerned; the notable distinction was that mutual funds trade after the market closes while ETFs trade like stocks throughout the market day.

That was the broad thrust of the argument then. For chapter six, he dug deeper and listed a number of distinctions that might help more advanced investors make their choices. Those differences were summarized in the following table:

“Index Investing for Dummies” compare mutual funds and ETFs

Wild also offered the following questions, all designed to make the choices clear:

  • Does this fund/ETF track the index well?
  • How much are the expenses?
  • Will there be tax consequences?
  • Do you want continuous pricing throughout the day?
  • How transparent is it? Do I know exactly what securities are in the fund?
  • Do I want to sell options on the fund, or short sell it?

There is some overlap between the questions in the table and those that followed, but by and large they give us a good set of criteria for choosing a fund or funds, whether mutual or exchange-traded.

Because no two investors have the exact same needs, there is no universal answer. But the author did lay out a rule of thumb distinction for index investing based on costs (which Bogle would insist is the key criterion):

  • Buy ETFs if you plan to buy and hold, since ETFs were (when this book was published in 2009) a bit cheaper than mutual funds.
  • Buy mutual funds if you are dollar-cost averaging or otherwise making small changes over time.

For those who like exotic birds in their cages, there are two other ways of index investing:

  • Exchange-traded notes (ETNs), which Barclays Bank defined as “senior, unsecured, unsubordinated debt securities ... designed to provide investors with a new way to access the returns of market benchmarks or strategies.” Wild called them “strange ducks indeed.” Think of them as the rough equivalent of bond mutual funds, because they are grounded in debt instruments and pay interest like a bond or bond fund.
  • Unit Investment Trusts (UITs) resemble mutual funds with an expiry date. Like bonds, they are set to expire at a specified date in the future, and when they do, you get your money back. While being held, UITs offer ongoing income (including dividends) or capital gains.

To capture ETFs, ETNs and UITs under one umbrella, some media outlets refer to them collectively as exchange-traded portfolios (ETPs) or exchange-traded products (again ETPs).

On a new topic, the author asks the rhetorical question: “Where do the major market indexes come from?” He then listed a few of the biggest index makers and their individual strengths and weaknesses.

The biggest of them was Standard & Poor’s, and its biggest index was the S&P 500 (as of 2008 and 2009). It is a subsidiary of S&P Global Inc. (NYSE:SPGI) and offers many indexes and funds based on them, including the SPDR Trust Series 1 (SPY). Note that the S&P 500 is a market-capitalization index, so bigger companies are more influential than smaller firms.

Dow Jones and Dow Jones Wilshire, the home of the Dow Jones Industrial Average (DJIA), has been in operation longer, for 125 years (as of 2019). This index is made up of just 30 stocks, all of which are hand-picked by editors at The Wall Street Journal. As a result, it is not of much help to anyone anymore.

Wild wrote, “The DJIA is an anachronism. It is a dinosaur. It is not representative of the entire stock market by any means and doesn't even do a great job of representing large companies! And yet it continues to be quoted, every single day, as a matter of bad habit.”

The Dow Jones Wilshire indexes came about when Dow Jones partnered with Wilshire Associates in 2004. In a bid to capture the entire stock market in the U.S., they created the Dow Jones Wilshire 5000. In addition, they developed the Dow Jones Wilshire 4500, which is the top 5000 firms, minus the S&P 500.

Lehman Brothers was also listed among the big index creators. However, it went bankrupt in 2008, no doubt just after Wild had readied his book for publication. The firm had created a fixed-income index based on bonds.

MSCI Barra was another index creator and originated at Morgan Stanley (NYSE:MS). The firm produced many global indexes and country-specific indexes for many nations with stock markets. MSCI indexes are cap-weighted.

Russell indexes include the relatively well-known Russell 3000, Russell 2000 and Russell 1000. The 3000 represents the broad market, the 1000 includes only the largest thousand stocks and represents the large-cap market and the mid-cap market. Finally, the two-thirds of stocks remaining become the Russell 2000 and represent the small-cap market. These are free-float indexes, which means they represent only the shares that are publicly available for trading.

In addition, several smaller index creators were listed:

  • FTSE is the British equivalent to the Standard & Poor’s in the U.S. Products include the FTSE 100, which is designed to represent the broad British stock market.
  • Morningstar (NASDAQ:MORN), which is best known for distinguishing among investing styles. In addition to large-cap, mid-cap and small-cap it also categorizes them by value, blend and growth strategies. The objective is to help with precise market allocations.
  • Dimensional Fund Advisors is known for its strong academic underpinnings; its founders were David G. Booth, Eugene Fama and Rex Sinquefield.
  • WisdomTree (NASDAQ:WETF) has links to academia because one of its founders is Jeremy Siegel, a professor at the Wharton School of Business and author of the best seller “Stocks for the Long Run.” His co-founder was hedge-fund guru Michael Steinhardt.

So, it turns out index investors can aim for above-average returns, albeit modest ones, by selecting an index mutual fund or index ETF with what are thought to be advantageous characteristics. As to the debate about the superiority of either mutual funds or ETFs, there might be a slight edge with ETFs, but nothing very significant.

Still, it is worth remembering Wild’s suggestion to choose ETFs for a buy-and-hold situation, and mutual funds for situations in which an investor is using a strategy such as dollar-cost averaging.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website

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