I encourage you to dive headfirst into the world of index investing with this 3-part series. It offers a systematic, low-effort way to create wealth in your sleep. Part 1 defines index investing and outlines key differences between index mutual funds / ETFs. Part 2 addresses why index investing beats active strategies and Part 3 will explain how you can adapt index investing to suit your custom goals.
Investing in Funds Versus Individual Stocks
When people become interested in investing, (typically around Level 4 on their path to wealth) an understandable first instinct is to think about buying individual stocks like Facebook (FB) or Proctor & Gamble (PG). It sounds sexy, it’s tangible, and this strategy is often glamorized by media pundits.
For the vast majority of investors, however, individual stock picking is a fool’s errand. It’s speculative and quite risky. It also takes a ton of time and effort. Upon realizing this, some choose to invest in “funds” which are composed of many different individual stocks. This provides all the benefits of diversification through a seamless single purchase.
Classifying Investment Funds (Active vs. Index)
Within this universe of funds, investors have two primary options: active funds and passive index funds. Active funds are portfolios of stocks picked by financial professionals seeking to beat the market using sophisticated research and analysis. In contrast, index funds aim to track the market (or underlying benchmark index) rather than outperform it. Here, we’ll drill into passive index investing and explain the different ways that you can use this strategy to your advantage.
A couple caveats before we dive in:
- For simplicity, we’ll focus exclusively on equity funds. You should be aware that there are also other funds that invest in fixed income securities, commodities, real estate, etc.
- When I discuss active funds, I’m referring to funds that are accessible to the masses. There are a wide variety of actively managed alternative investment funds available only to individuals classified as accredited investors
- Some of these alternative funds generate incredible returns, but they’re not an option for most people. Thus, we won’t talk about these for now
Types of Index Investing
As mentioned above, index investing is a strategy that involves passively investing in a fund that aims to track the returns of a market or underlying benchmark index. Within index investing, there are two main types of funds to choose from: passively managed index mutual funds and Exchange Traded Funds (ETFs). While these two investment vehicles are closely related, it’s important to understand how they differ as you build your index investing foundation.
Passive Index Mutual Funds
Remember those old Geico commercials about the caveman…?
Index-based passive mutual funds are like the Geico of investing. They’re incredibly easy to use!
While technically not listed on a stock exchange, you can easily buy them at any online brokerage firm (Vanguard, Charles Schwab, Fidelity). Many of these firms even allow automatic investing in mutual funds, letting you put your finances on autopilot. For instance, you could set up an automatic monthly sequence that transfers $500 from your checking account to your brokerage account. Then, immediately invest that money in an index mutual fund…all without lifting a finger.
These funds are a great tool for those of you searching for the straightest, hassle-free path to wealth. They settle once per day after the markets close so you won’t be refreshing your browser every 20 seconds to see how a fund is trading. Additionally, you don’t have to worry about purchasing individual shares like you do in an ETF (more on this below). This means every cent of that $500 contribution will be invested immediately.
Drawbacks to Index Mutual Funds
While these funds are great, recognize that there are a few trade-offs to consider. First, index mutual funds tend to be a bit more expensive than ETFs. It’s marginal, but I often see passive mutual funds with expense ratios that are a few fractions of a percent higher than their ETF counterparts. Second, the taxes on mutual funds are typically higher than ETFs. Finally, index funds may require a sizable minimum initial investment amount. Unfortunately, this can discourage newbie investors with less to contribute.
The drawbacks should not in any way dissuade you from investing in these funds. The convenience more than outweighs the marginal costs mentioned for many people. While index mutual funds are slightly more costly than ETFs, they are still far cheaper than actively managed funds. Perhaps most important, the automatic functionality ensures you’ll keep investing consistently and without emotion. That’s a recipe for caveman wealth creation if I’ve ever seen one!
Passive Exchange Traded Funds (ETFs)
Think of an ETF sort of like a passively managed index mutual fund that trades in real time. ETFs are listed, priced, and traded immediately during market hours. It’s a single security composed of many individual stocks, and can be engineered to track a broad market index or fulfill a particular investing need. For instance, SPDR runs one of the most popular ETFs (SPY) that seeks to mimic the performance of the diversified S&P 500 index. Alternatively, Charles Schwab runs a fund (SCHD) that tracks the Dow Jones Dividend 100 Index, allowing investors to increase their dividend exposure.
Like mutual funds, ETFs are easy to trade and provide a great way to diversify across hundreds or thousands of individual stocks with the click of a button. Their expense ratios are often cheaper than passive mutual funds because they require less personnel, marketing, and administrative work. This fact, along with more favorable tax treatment, make ETFs a popular choice among the most frugal investors.
By now, you’re probably confused. Given the ability to trade ETFs instantaneously during market hours at lower expense ratios, why would anyone opt to invest in mutual funds over ETFs? Let’s talk about a few of the downsides related to index investing with ETFs…
Drawbacks to ETFs
First and foremost, ETFs don’t provide the same potential for automation as mutual funds. They’re live securities trading real-time on an exchange, rather than a fund that settles trades after markets close. While not difficult, buying an ETF requires you to log into your online account and consciously make a purchase. It also requires you to make a transaction denominated in shares, not dollars, which can be messier.
Consider the $500 automatic investment we discussed earlier. Let’s say you wanted to invest that same $500 in an ETF that was trading at $30/share rather than the mutual fund. Turns out, you can only invest in 16 shares for a total of $480 (16 shares X $30/share = $480). This is because investing in 17 shares would cost more than $500. You’re now left with $20 sitting in your brokerage account collecting dust until your next trade. This may seem inconsequential at a small scale, but minor inefficiencies like this can lead to dramatic differences in your wealth when compounded over a 40-50 year time horizon.
Another thing that trips people up with ETFs is the instantaneous nature of trades. Mutual funds force a certain level of patience with their settlement after market close, but ETFs can be traded at a moment’s notice with high frequency. This may tempt investors that lack experience dealing with market volatility to make rash decisions. It’s particularly detrimental if you’re investing with a brokerage that charges commissions on each trade.
Key Takeaways on Index Investing
So, what’s the best way to invest in indexes? Passive index mutual funds or ETFs? Ready for your favorite answer in all of personal finance…drum roll please!
It depends.
I know how unsatisfying that may sound, but it’s true. This post has laid out the most crucial information that you need to make an informed decision. It’s on you to choose what’s best for your lifestyle and personality.
If you recognize that you don’t have the discipline, time or desire to consistently log into your brokerage account to buy ETFs, save yourself the headache and stick to passive mutual funds. Sure, you might pay a couple more bucks per year in expenses and taxes. However, the guaranteed consistency provided by automatic investing will more than justify the cost in many cases.
With all of that said, I prefer to invest in indexes with ETFs. As lame as it may sound, I happen to enjoy the process of investing and spending a little time with my money each month. It helps keep me motivated and engaged. While the ETFs perform all of the hard work diversifying and tracking indexes for me, I appreciate feeling like I’m actively participating in my wealth creation even though I’m passively investing.
We could debate the nuances and technicalities of index mutual funds versus ETFs all day, but that’s not the point. No matter which option you choose, you’re winning the game by index investing. Period. You just have to get started.
In Part 1 of this series, we’ve built your foundational knowledge around index investing. Be on the lookout for future posts to learn more about the benefits of index investing compared to active strategies and how you can adapt index investing to suit your personal needs.