Everything about Index Funds and ETFs

What are Index Funds?

  • The index performs the same as a benchmark such as S&P500
  • In the long-run, will perform slightly less than the actual benchmark due to fees
  • Can be both a mutual fund or ETF
  • Passively managed: infrequently buy and sell investments

Benefits of Index Funds

  • Lower expense ratio than actively managed funds
  • Immediate diversification since the investment is in an index, not an individual company
  • Low tax exposures
  • Tend to outperform active investors over time

Risks of Index Funds

  • Exposed to the same risk that the index is following
  • No downside protection
  • Opportunity cost of capital since you don’t have a choice to choose the winners
  • Cannot trim under performers

What are ETFs (Exchange-Traded Funds)?

  • Exchange traded funds: basically a mutual fund that’s listed on the exchange that can be easily bought and sold, unlike the typical mutual fund
  • Process starts by an individual placing shares of the ETF through a brokage account, on the other side, someone sells you those shares => compared to a mutual fund, this has to be executed by the fund manager which sends you a prospective and a list of paperwork
  • ETFs are bought between buyers and sellers, question is how are shares created => only can be created by authorized participants (AP)
  • These APs will enter an agreement to create a basket of ETF shares. AP will then go out and buy all the shares needed for the ETF. Once bought, the AP exchanges the shares bought with the ETF shares
  • This process goes on continuously => as the demand of ETF increases, the AP follows the same process of going out, buying the shares required, then exchanging it for the ETF shares
  • Can work in reverse: If there is too much supply of the ETF shares, the AP can sell off their ETF shares and will get back the securities basket
  • Therefore, if value of ETF exceeds the securities basket, the AP will create more shares by trading basket of securities for ETF shares. If value of ETF is less than the securities basket, the AP will sell their ETF shares in exchange for their basket back

Benefits of ETFs

  • Intraday trading: Can trade anytime the market is open
  • Lower costs: ETFs cost fund companies less so ETFs cost investors less
  • Tax efficiency
  • Transparency: Must disclose the basket of shares needed to process the create/redemption daily and is usually aligned with the holdings of the ETFs
  • Access to anything

Risk of ETFs

  • Flash crashes: if ETF holds 1 stock that suddenly underperforms significantly, the ETF will suddenly under perform to the index
  • Commissions: every transaction has a cost
  • Spreads: The larger the bid ask spread, the more it will cost to trade the stock. Liquid funds = penny spreads, illiquid funds = >4% spreads
  • Fair Value: Most ETF trade close to NAV (net asset value), can check by going to Google and entering the ticker and end it with .iv. This is to check that the ETF is trading in line with it’s true asset value. Can get out of sync for foreign funds because the foreign markets have different operating hours than the US exchanges
  • Counterparty Risk
  • Derivative Use: Use of swaps (inverse/leverage)
  • Securities Lending: Risk of the underlying collaterals and are not often disclosed
  • Not all ETFs are created equal (even if it’s tracking the same index)
  • Leverage ETFs: In the long-run, the losses / gains compound. An example would be if you went 3X Bull, but it went down 25%. As it goes back up 25%, you will not net back at 0 but much less.
  • Tax Treatment: Taxes are different depending on product category => Equities at 15% vs currency ETFs at 35%