your 401(k) #11: index funds & etfs
By definition, passive is the opposite of active. It’s used to describe someone or something that accepts whatever happens without resistance or action.
The same is true when it comes to the difference between actively managed funds and passively managed funds.
- An active, or “managed”, fund is run by professional stock pickers who invest in certain stocks/bonds of their choosing.
- The managers of a passive fund allow an index to dictate the components of its portfolio.
That’s why passively managed funds are also called index funds. The portfolio of an index fund matches the components of an index and aims to mimic its return.
For example, a “500 fund” like the Vanguard 500 Index Fund (VFINX) would invest in the same 500 companies tracked by the S&P 500, while a “2000 fund” like the Vanguard Russell 2000 Index (VRTIX) would invest in the same 2000 companies tracked by the Russell 2000. (Note: These particular funds are solely examples; I have no connection to nor am I recommending these funds).
Investing in index funds can be beneficial for a few reasons:
- Lower cost
- Actively managed funds typically charge around 1% to 1.5%, but some can charge upwards of 2% of assets or more. That means that for every $100 you have invested, the managers charge you $1.50 to manage it.
- Index funds, on the other hand, are often significantly cheaper, charging as little as 0.05%, or 5 cents for every $100 invested.
- While a 1% difference may not seem like that big of a deal, it can have a HUGE impact on your nest egg.
- Two friends, Sarah and Jess, are both 25 and have committed to invest $5,000 per year until they turn 65 years old.
- Sarah invests all of her money in S fund, and Jess invests all of her money in J fund.
- S fund is an index fund that mimics the S&P 500 and costs 0.15% per year, while J fund is a large cap actively managed fund and costs 1.15% per year. (They invest in similar stocks, but J fund costs more.)
- Over the course of 40 years, both funds earn an average gross annual return of 7%.
- After subtracting S fund’s 0.15% annual fee from its total 7% annualized return, Sarah’s money ends up earning 6.85% net per year. She reaches 65 years old with a nest egg of $1.03 million.
- Jess, on the other hand, only earns a net annual return of 5.85% (7% total - 1.15% fee), and ends up with a nest egg of just $794k.
That’s right - a 1% difference in fees cost Jess $238,000 !!!! Loco.
- More tax efficient
- The components of an index don’t change dramatically or often, which means that an index fund is able to hold onto stocks for longer periods of time (versus active managers who buy and sell more frequently in an effort to outperform their benchmark).
- Holding stocks for longer periods, specifically over one year, lowers the tax rate on any profits.
- Profits made on stocks held for less than one year are called short-term gains and are subject to ordinary income tax rates.
- Profits made on stocks held for longer than one year are called long-term gains and are subject to the lower capital gains rate (15% for most tax brackets, but as low as 0% - that’s right, ZERO% - for the lowest income tax brackets).
- Effortless diversification
- Index funds typically invest in hundreds (think S&P 500), sometimes thousands (think Russell 2000) of securities.
- This level of broad diversification can lower your risk and volatility because the fund spreads your risk across so many securities.
- Can't outperform their index
- By design, index funds cannot outperform their index.
- You may not think that’s a big deal when the market’s going up (everyone’s making money, yay!). However, if the index is going down, your index fund goes down with the ship too.
- This is where active management can come in handy.
- If some stocks in the fund’s portfolio are going down, active managers can choose to sell them and invest that money elsewhere. This active intervention could save the fund and investors (YOU) from major losses.
- Passive managers don’t have that kind of control. They have to stick to what’s in the index.
Exchange Traded Funds (ETFs) are often confused with index funds. They’re very similar in that they track and aim to mimic an index. However, they differ in the ways and frequencies with which you can buy/sell them.
- Investing in index funds means buying units of the fund from the fund itself, and you can only buy/sell units once per day.
- ETFs, however, are essentially index funds that trade like a stock on an exchange.
- Flexibility and Liquidity
- Trading on an exchange means that you’re able to buy/sell ETF shares as many times as you want while the market is open.
- The price per ETF share fluctuates throughout the day, whereas the NAV of an index fund is recalculated once at the end of each day.
What advantage does being able to buy/sell ETFs at any point during the day give you?
If the market is tanking (like it did in 2008, Aug 2015, Jan/Feb 2016, etc), you may be able to sell your ETF shares before their value drops even lower.
With an index fund, however, you can’t sell your shares until the end of the day. Even if you login to your retirement account in the morning and say you want out of that particular fund, your transaction won’t be processed until the end of the day. At that point, the index may have dropped even further, which could result in you selling your shares at a lower price than you’d like.
- Low cost
- ETFs can also be very cheap, sometimes cheaper than some index funds.
- But just like index funds, there are “good” and “bad” ETFs (certain ones perform well in certain markets and vice versa).
- Make sure you know what you’re investing in, and why and when you’re investing in it!
- Transaction costs
- Just like stocks, when you buy/sell ETFs in a brokerage account (like Scottrade, Robinhood, etc), you pay a fee to execute that transaction, sometimes as much as $7 per trade.
- If you buy/sell ETF shares often, those trading fees can add up quickly and eat away at your potential profit.