The best way for an investor to invest in an index is to use a well-diversified, low-cost fund as a vehicle. For international (non-U.S.) investors, this will generally be an exchange traded fund, the ETF. In this article you will find the key theoretical aspects to better understand these investment vehicles, starting with the differences between ETFs and other mutual funds, followed by the advantages of passive funds over active funds. Then two separate articles will address the characteristics of ETFs and the more practical aspects of ETF investing.
Mutual funds and ETFs
There are two main versions of funds:
- Mutual funds. These are funds managed directly by a financial institution. To invest in a mutual fund, you do not need to have access to the stock market. You can invest in mutual funds through a financial institution such as Vanguard. Unfortunately, this is rarely the best option outside of the United States or for very large investment amounts only. In the European Union or Switzerland, the best option for private investors is to invest in an ETF (see below) to have broad access to the stock market.
- Exchange-Traded-Funds (ETFs). These are exchange-traded funds for which you will need a broker as intermediary. Thanks to the stock exchange platform of a broker offering advantageous transaction prices (maximum 1-3 Swiss francs per order), you will be able to buy the shares of an ETF as if it were a share of an individual company. The largest and most recommended issuers are BlackRock (iShares) and Vanguard, which provide very popular ETFs due to their large size and attractive prices.
According to various sources, ETFs have now surpassed mutual funds as the passive investment vehicle of choice globally in the second half of 2021. For active investing, mutual funds remain the dominant format. Unlike the U.S., many jurisdictions have not approved the broad application of active, non-transparent ETFs. These countries often reserve the ETF format for passive investments to avoid misleading investors. Thus, in most countries, ETFs have become the vehicle of choice for passive investments.
ETFs are also generally more tax efficient than mutual funds: Unlike traditional funds, ETFs generally do not need to sell their underlying securities. Instead, they can deliver baskets of securities “in kind” to authorized participants who create and redeem ETF units. The trading activity and any capital gains therefore occur outside the fund, so there is no tax “pass-through” to investors. Although this U.S. tax advantage does not apply in every jurisdiction, ETFs are the vehicle of choice for international private investors: They are often less expensive than mutual funds and more transparent about their constituents. They are also more liquid, offering intra-day trading, whereas mutual fund trades often take a minimum of one day to process.
The advantages of passive funds over active funds
Funds with an index-tracking approach, also called passive investing, offers the following advantages over actively managed collective investments:
- Better risk-adjusted performance: You reduce the risk of a large loss if a company or an entire industry experiences difficulties;
- Superior diversification: Over the long term, only a few companies outperform the overall market and it is very difficult to identify them in advance;
- Lower costs* than an active approach involving frequent buying and selling and a manager charging for services.
* Note on costs Passive mutual funds and ETFs have lower costs than active ETFs. These lower fees are the result of economies of scale due to the high volume and lower staffing requirements for passive management. In addition, large passive funds have already been under greater cost pressure, although similar pressure is now being applied to actively managed funds. According to Morningstar, average expense ratios have halved in two decades, from 0.93% of the total amount invested in all funds in 2000 to 0.41% in 2020. Active funds are starting from a higher level, and there is still room to go down further. In any case, the passive strategy recommended here can already benefit from low fees today, while the decrease in fees for active strategies will still take time and will never reach the level of passive management. Among the largest index fund and ETF managers, Vanguard remains the cheapest fund provider with an expense-to-asset ratio of 0.09%; next is State Street Global Advisors at 0.16%. BlackRock (which owns iShares ETFs) is third with 0.25% due to its broader range and larger offering of niche, and therefore more expensive, products. However, no single provider is better or more attractive for all indices and they often use different indices. A thorough comparison is therefore necessary, because size, domicile and other criteria are important when choosing ETFs.