Index Funds vs ETFs Explained

To some, index funds and ETFs are world’s apart. To others they are one in the same. To expats and non residents, one is usually our gateway to the other.

This week we are going to cover what each of these is, where they are similar, where they differ and most importantly, which is a better investment for expats and other non residents.

Let’s be clear right from the off. Investing in either can provide strong investment returns they share a number of key benefits if you pick the right ones, namely:

• Diversification
• Low costs
• Tax efficiency
• Simplicity

Whilst those are compelling reasons to invest, there are some key differences to be aware of. Some of these are subtle. Others not so much.

A little help from Vanguard

To help emphasise the differences, it’s worth taking a trip over to Vanguard. Not just because they are basically a not for profit organisation. And not because they were the ones that actually pioneered index investing in the 1970s. And not even because they are one of the largest fund managers in the business.

No, we’ll use Vanguard because they offer a good range of both types of funds so its not in their interests to present one as any better than the other. We can look at index fund and ETF options without bias.

On their UK website, Vanguard show detailed information about each fund they offer. More importantly, they also offer a summary of key information. Not only that, an option to invest now button sits at the bottom of every single one, implying that their summary might just be enough info for you to make up your mind and pull the trigger.

For our purposes we’ll take a look at two UK funds. One index fund and one ETF. We are going to compare two funds that track the FTSE100 index. We can do that because you can invest in ETFs that track indices. We’ll call them ETF tracking indexes for now.

In case you don’t know, the FTSE 100, often referred to as the Footsie is an index that tracks the 100 largest public companies by market capitalisation that trade on the London Stock Exchange (LSE). The name Footsie is an acronym of the index’s original parent companies, the Financial Times and the London Stock Exchange. It represents more than 80% of the LSE’s market capitalisation.

The image below shows Vanguard’s summary information for a FTSE 100 Index Fund (Index Unit Trust) and a FTSE100 ETF (UCITS ETF). Can you spot the difference between them?

Spot the difference

Eagle eyed readers will have spotted one difference: The ongoing charge (OCF). The index fund is 0.06% compared to 0.09% for the ETF.

On the face of it, the only difference between the index fund and the ETF is cost. All other key characteristics shown in these Vanguard summaries are the same.

And that’s because both the Vanguard FTSE 100 Index Unit Trust and the Vanguard FTSE 100 UCITS ETF are essentially the same thing. Both follow the FTSE100 index. Both have the same companies in the fund in the same amounts. Both have the same Risk Level and on and on.

You’d find the same thing if you looked at the Vanguard S&P 500 index fund vs ETF equivalents or any other combination where both funds track an index.

And that’s because in reality they are both are kind of index funds!

You’d be forgiven for feeling confused right now, but don’t be. Index funds and ETFs have differences but the main idea behind them can be the same.

Whereas index funds always track indices, ETFs sometimes do. When they do, they are very similar investment vehicles to index funds. I like to call them index tracking ETFs.

Only when ETFs don’t follow indices do bigger differences being to appear.

Let me explain.

What is an index fund?

An index fund is a basket of stocks or bonds that tracks an index.

Stock indexes are essentially collections of stocks meant to represent the stock market or a portion of it. (Stocks are often referred to as shares in the UK).

Perhaps, the most famous index of all is the S&P500 (Standard and Poor’s 500). This is an index that tracks 500 publicly traded US companies. It is considered by many to be the best indicator of US stock market performance. Similarly, the FTSE100 is the UK equivalent.

What is an ETF?

An ETF (Exchange traded fund) is a basket of stocks that trades on an exchange. And note, though it can follow an index, this basket doesn’t nessecarily have to follow one.

An ETF can be full of pretty much anything you want it to be.

And this is an important point. You see, there’s a wealth of info out there that indicates the best way to grow your wealth is through investing in index funds. (We are going to discuss this in a lot more detail below in ‘active vs passive management.’)

For now, here are the key differences between these two types of fund that I think you need to be aware of.

How and where you buy your fund

You typically buy index funds directly from the index fund company itself. On the other hand, ETFs are freely exchanged on the stock market. This means anybody with a investment account can buy ETFs, whereas only investors eligible to buy directly from the fund provider can buy index funds.

In practice this often restricts certain groups from buying index funds, such as………..you guessed it…… expats.

Whilst there are the odd platform out there that does allow index fund investment from overseas, as yet, I’ve not come across one that doesn’t either charge a high fee or require a very high minimum investment for the privilege or both. But don’t worry, though, there are some decent options for buying ETFs. We’ve talked about a few good investment platforms that allow you to buy ETFs here if you don’t already have an account.

And as you soon see, when push comes to shove, ETFs are probably going to better for those of us who live overseas anyway (just).

Under the hood

As already touched upon, you can be faced with two very different scenes when you lift the hood on these two types of investment.

Just to be clear, index funds always contain baskets of stocks that follow an index. On the other hand an ETF can hold pretty much anything. More common examples being gold or Bitcoin.

The key for us, is simply choosing an ETF that tracks an index.

Minimum investments required

When you invest in a fund you often have a minimum investment cut off amount.

In other words, you have to invest a certain amount of money in a fund.

The minimum investment for an index fund is often higher than for an ETF. That’s because you can only purchase index funds from particular platforms. If you purchase from a platform that has both like Vanguard UK these minimums maybe the same.

For your information, Vanguard’s lowest investment amount is £500 no matter which you choose. However, more likely a minimum investment for an index fund will be in the thousands of pounds.

The types of platforms that enable expats to invest in index funds will typically have even higher thresholds.

On the other hand all investment platforms should give you access to ETFs. And because ETFs can be bought and sold just like stocks you can invest in as little as one share.

There are plenty of ETFs out there that sell shares for less than a fiver!

When

The price of an index fund is calculated at the end of the trading day and as such you can only buy an index fund at that time. In practice this means no matter when you place your order to buy throughout the day, the order will only go through at the end of the day.

The downside of this is that the price may be higher at the end of the day than it was earlier on. Lots of things can happen during the course of a day that impact share prices.

Buying ETFs on the other hand, is a different kettle of fish. They can be bought and sold throughout the day based on real-time pricing. It’s not that big of an issue really, but I for one do like to buy shares in real time. I’m not really bothered if the share price decreases after I’ve bought my shares because I’m in it for the long term.

Sophisticated orders

Index funds are limited to buying and selling at one point during the day. On the other hand you can treat ETFs in just the same way as individual shares, meaning you can complete all kinds of sophisticated order types if you so desire.

For sure, this is only really relevant if you are some kind of (crazy) day trader or (so called) sophisticated investor. It won’t impact most of us. On the other hand, the next one just might.

Automation

You see, it’s usually pretty straight forward to set up automatic orders with index funds.

This means you can automatically send money directly to your investment account once a month when you receive your salary without even thinking about it. The fund provider will handle allocating the money to your funds.

It didn’t used to be possible with ETFs. At least not with the platforms I used but that seems to be steadily changing. So I’d put it this way. With ETFs you might not have access to automated trades but with index funds you nearly always will.

Now, buying shares, these days is pretty much stress free anyway. A couple of mouse clicks usually does the trick.

In my experience, the only time when automation is really helpful is in times of market stress.

Essentially, its not easy to buy shares when the markets are dropping double digits in front of your eyes.

Active vs passive fund management

All index funds are passively managed. They attempt to closely track a benchmark index like the S&P 500 or FTSE100.

In practice, this takes decision making out of the process. The S&P500 contains Apple for example. If the price of shares in Apple goes up by 10%, then the fund manager (or algorithm) simply buys 10% more Apple stock. Easy. No decision to make here.

On the other hand active management requires a fund manager (or some kind of fancy algorithm) that makes decisions in order to try and get higher returns (than the index). Active managers that consistently beat the market can become famous. A certain Warren Buffett springs to mind.

The active vs passive debate is a big one. We’ve written dedicated articles about it. And others have gone so far as to write books focused entirely on that one subject.

My take on it goes a little like this. It maybe possible for some outstanding individuals to beat the market. However, more and more evidence is mounting that these people are extremely rare. Because of this, finding one of these super investors is just about as difficult as choosing an individual company to invest in.

People think they can just look at a fund managers track record to decide. If the fund has been outperforming then hey presto!

If only it were so simple! The key thing is the past is not an indicator of future performance. In fact, the more successful a fund manager has been the more likely they are going to underperform in the future.

Feel free to do your own research into this if you aren’t convinced. I’d recommend starting with SPIVA.

But before you do have a look at the chart below showing the US stockmarket (S&P composite 1500) vs active managers. In other words a US stock market index vs active management:

Total US stock market index vs active managers

The charts above don’t look very good for active managers. If we give them the benefit of the doubt by assuming you don’t care about risk and just look at the absolute returns (light blue), over 3 years 72% of them underperformed the index. Over 5 years 75% of them underperformed the index. Over 10 years 86% of them underperformed their index and over 20 years 90% of them underperformed the index.

In other words, if you went with the index you outperform 90% of active managers over a 20 year period!

In the western world you expect to live into your mid 80s, so even if you are in your 60s you should be investing for at least 20 years. In your 50s 30 years. In your 40s 40 years. You get the picture.

I think it’s pretty obvious that as your time horizon increases so does your chance of outperforming active managers by following an index.

But perhaps what’s not quite as obvious is the fact the fund manager that outperforms during one period tends to underperform during the next period! That means picking a fund manager based on a good track record could be just about the worst thing you can do.

If they did well last year, there’s a bigger chance they are going to do badly this year and if they do manage to beat the index next year, there’s even less chance they’ll beat it the following year.

I’ve got friends that see this data and just think there must be some catch and still try to choose fund managers with good track records. ‘Yeah yeah but Manager X has been providing 12% returns for the last 10 years……..”

But I think Morgan Housel puts it best:

Simple almost always beats complex. That’s true for investing, mortgages, insurance, and everything else related to money. If there’s one thing I wish I knew when I graduated, it’s that.

And to be honest, I totally understand. The idea the active fund managers underperform indexes is pretty counterintuitive when you first come across it.

However, when you look into it, things become a little clearer. See ‘Why index funds rule’ below.

Fund costs

Index funds and ETFs can both be extremely low lost ways to invest. If they both follow an index that is. But if they are different, it will usually be the index fund that is cheaper. In turn this will have a slight impact on index fund vs ETF performance. In the Vanguard FTSE 100 example we looked at in the beginning of this article there was a cost difference of 0.03%.

As an example lets say you got 7% returns on £100K over 25 years of saving for retirement with with your index fund after fees. You’d end up with just about £543,000. With the ETF version you’d end up with £539,000. That’s a difference of approximately £4,000.

Not a lot when we are talking over half a million pounds, but a difference all the same. So I think what this means is, if you have a choice between the two you’d usually want to go for cheaper option and if that’s the index fund go for that one. However, if the index fund isn’t available or you have another reason to go with an ETF, just go with that and don’t sweat the difference. This certainly won’t make or break your investment success.

Tax efficiency

Our next topic is bound to dampen your mood.

I mean let’s face it, nobody likes talking about tax.

I don’t know anybody who knows anybody who likes talking about tax but in this case we can’t avoid it because this is a big benefit of both index funds and ETFs.

You see they are both highly tax efficient. And this can be particularly important for expats that don’t have access to tax sheltered accounts that residents do. Think ISAs and SIPPs in the UK.

The big reason for this tax efficiency is that funds following indices don’t change their holdings very often. This is powerful because it does wonders for reducing capital gains tax.

Now just to be clear. They are both super duper tax efficient but, wiser men than me and men in the know about this stuff say that the underlying workings of ETFs make them even more tax efficient when following indices.

That’s because, so they say, ETFs involve Authorised Participants (APs) which allow tax free in kind transactions and because they are traded on exchanges between investors they don’t generate capital gains events.

But again, just to reiterate this only works perfectly for an ETF that follows an index. If an ETF was managed by a highly active manager that was constantly buying and selling shares tax costs could be high.

Index funds vs ETF summary

ETFs	Index Funds
Traded freely on an exchange	Usually purchased directly from provider
Doesn’t just hold baskets of stocks following indices	Holds only baskets of stocks following indices
Can invest with less money	Typically requires a larger minimum investment. Anything up to six figures is common
Buy and sell when you want	Limited to trading once per day
Sophisticated order types possible	Only buying and selling possible
Can’t make automatic investments or withdrawals	Can make automatic investments and withdrawals
Both actively and passively managed funds available	Limited to passively following indexes
Marginally higher costs	If there is a difference between an index fund and an ETF, the index fund will typically be slightly cheaper
Don’t pay as high a level of tax	Index funds are tax efficient. The taxes you pay are pretty low and beat most funds. However, ETFs are even more tax efficient

So which is better?

As you’ve probably gathered as we’ve been going along, either of these makes for an excellent choice, however, as an expat, I think ETFs just edge it.

The small but present tax advantage is a bonus, but the main thing is ETFs are available at all the big expat investment platforms whereas index funds aren’t.

Why do index funds rule?

It’s worth going into a bit more detail on this active vs passive management malarkey as this is a concept that really seems counter intuitive when you first come across it.

When you think that a lot of these active mangers are exceptionally intelligent, highly talented, have access to all the best tools and equipment, are backed by some of the best teams in the world, possess plenty of money to invest in all the best research and latest technology and are highly experienced, why an earth do the vast majority of them fail to beat a simple index?

That’s vs an index that is basically just buying everything automatically. How can it be?

Here are some key reasons why index funds outperform. (which I mostly got from Winning the Loser’s Game by Charles Ellis).

Active management fees

There are two main ways to invest. You can passively follow an index or you can actively manage your investments. Index followers don’t underperform or over perform. They simply get the average.

Now, on the other side of the coin are active managers, who decide to buy and sell certain stocks at certain times. Basically, they want to buy the ones they think will go up more in the future and sell the ones they think will go up less.

This sound’s great in theory but here’s where it starts to unravel. If one of them wants to buy a stock then another one must sell that stock to them. After all, the indexers only buy and sell when the index tells them to, not when an active manager wants to trade. When you stop and think about it indexers are just bystanders looking on at what these active managers are doing.

When active managers trade, they do so with each other. In fact 99% of trading is done by institutional investors. This means when one manager buys shares of a company he thinks will go up, the chances are he’s buying from another manager that must think it will go down. One of these managers must be right and one of them must be wrong. They can’t both be right. The ones who got got it wrong will definitely underperform the average (that indexers get), but even those active managers that outperform their peers may struggle to beat indexers.

Think about it this way. If active managers spend all their time trading with one another then active management itself has to be a zero sum game. The overall results must be the same as the overall results gained by indexers. In other words if you split investors into two groups active managers and indexers, as a whole they’ll both get exactly the same returns. But there will be a big difference between what investors get because active managers charge higher fees to pay their own inflated salaries. Not to mention those of their teams, and all the other associated costs like offices, computers, research and the like.

Active management competence

Again, this will seem pretty counterintuitive, but the fact is active managers have improved beyond recognition. They are in fact some of the most highly educated talented people on earth. They have access to technology and expertise that wasn’t available even just a few years ago. The problem comes back to the fact that 99% of trades are done by professionals. It means these active managers are fighting amongst themselves!

Because they’ve all got the best education, the best resources and the best tools it is very difficult to beat them. Luckily indexers don’t have to. They leave them to use all their skills and cunning to fight each other and unfortunately for a lot of them the results aren’t pretty.

Active managers are the market. They are the ones who under or out perform the market. Indexers just get the average.

Job safety for financial professionals

With all this negatively aimed at active managers, you might think I don’t think it’s possible to beat an index fund or in turn the market, but that’s not the case.

Why? Well, people have done it. How much is down to luck and how much is down to skill is debatable, but the fact remains it can be done.

The guys who have had the most success at outperforming have tended to do something radically different to everyone else. Oftentimes, their funds loose massive amounts of money only to recover and reach new highs that handsomely beat the market in the end.

Attempting to beat the market is great, when in the end it pays off. It can turn a fund manager into a minor celebrity and make them incredibly rich.

But trying to beat the market can be lethal if you aren’t careful. Most investors aren’t patient when they start loosing money, particularly when they are paying higher fees.

Fund managers that loose too much money will find themselves out of a job. Arguing that the companies in their funds are primed for a revival simply won’t cut the mustard. Investors will move their money elsewhere and fund company bosses don’t like that at all.

Because of this lots of active managers end up investing in most of the same companies as the index. They will probably include a few differences to hide the fact. Perhaps allocating a bit more capital to one company than another or choosing to invest in a few companies that aren’t included on the index. Essentially though, they’ll be indexers too when you look close enough. The only real difference is that they’ll be charging you more money for their services.

But can we really blame them? Active managers have families and responsibilities too. A lot of them simply won’t risk doing anything radically different to an index because it may cost them their job.

When an active fund is similar to an index it follows that it will get similar results. Sometimes it might underperform by a little, but at other times it might over perform a little.

Sounds reasonable enough until you consider the fees again. Actively managed funds charge more and this needs to taken off their returns. And unfortunately for them, when fees are removed from returns they’ll probably end up underperforming even when before fees they out performed. And by the way, at all other times they’ll definitely underperform! They are fighting a pretty much unwinnable battle from the off.

But from an active managers point of view this underperformance will usually be fairly manageable. And most importantly a few percent of underperformance won’t get you fired. Doing this keeps their job safe. Food on the table and their kids in school. Can you really blame them?

Investing in a funny old world

It is a funny old world we live in. And stock prices reflect what is going on in this funny old world. If a pandemic occurs, lots of companies will suffer so share prices will go down. If a war breaks out in the middle east oil deliveries will be disrupted and the prices of oil company shares will shoot up.

But who knows when the next pandemic will cripple the world’s economies or when the next war will break out? And while we are on it, has anybody had any luck foreseeing the next tsunami? Do we think even one person can write anything resembling an algorithm to predict how greedy we humans can be next time financial markets begin bubbling over? Is it at all possible to measure the panic we are going to feel when the markets crash as they inevitably will do?

I think the short answer is, no! When push comes to shove, predicting what is going to happen in the world or markets is going to be pretty difficult at the best of times if not nigh on impossible.

Buy the haystack

One of the best descriptions of stock picking and index funds comes from Bernard Malkiel in his seminal work ‘A Random Walk Down Wall Street.’ Malkiel is convinced looking for individual stocks or active managers that will be successful is like looking for a needle in a haystack so he says just ‘buy the haystack.’ In other words you just buy everything you can get your hands on. And the simplest, most effective, most tax efficient and cheapest way of doing this is by choosing the most diversified index tracking fund you can get your hands on.

Picture yourself investing £10K in the stock market 25 years ago. To ensure you didn’t put all your eggs in one basket, you divided your cash equally between the shares of ten companies. Unfortunately for you 9 of the 10 companies went bankrupt and your shares became worthless, but one managed to stay in business. If that one was Amazon your original £1K investment in Amazon would now be worth around £2 million. 90% of the companies you invested in went to zero but you still became a multimillionaire. Nice work if you can get it!

Now, in reality for the average person 10 companies won’t be enough to ensure you invest in the next Amazon, but don’t worry these days you can easily invest in funds that follow indices containing thousands of companies.

Of course, with thousands of companies, you’ll have thousands of stinkers too but here’s the key. You’ll guarantee you have the Amazons, the Apples, the Facebooks, the Netflixes, the Teslas too. And these will more than make up for the laggards.

Think about it this way. A company can only loose 100% of its value, where as it has the potential to grow infinitely. 500%, 2000%, 5000%, take your pick!

And think how good you’ll feel knowing you are practically invested in everything. When you invest in a share of a company, you essentially own a piece of that company. As the business makes more money, they’ll either reinvest it into the company itself which will increase the share price or they’ll pay out a dividend which you’ll receive directly into your investment account.

With broad global indices you’ll basically have tiny pieces of all the businesses that matter. Just imagine sitting in Starbucks sipping coffee, knowing that an incy wincy piece of the profit is going to your index fund. Then perhaps you send a message on your iPhone knowing full well that’s another one of the companies your fund contains. Then perhaps your friend turns up with the latest Samsung phone and starts telling you about her new Mercedes. You aren’t particularly interested in either of those companies products but you know your fund contains shares in both of them so deep down you thank your friend for lining your pockets with a tiny bit more money!

Essentially, when you invest in a fund that follows a global index the operation of the whole world around you will be contributing to your investment account. Even companies you don’t own will be doing business and buying things from companies you do own. Unless you are a hermit, you, your family, your friends, your work colleagues and acquaintances will constantly be contributing to your future.

Inbuilt filtering mechanism of an index

Lots of people mistakenly think you miss out on growing companies if you follow indexes but that’s not the case. I heard this explained best by J.L. Collins, the author of ‘The Simple Path to Wealth.‘

If you invest in a highly diversified global index fund you’ll be invested in all the companies that matter. Some of these will be smaller and some will be bigger. Some of the smaller ones will grow rapidly into bigger ones and some of the bigger ones will shrink into smaller ones (and in some cases drop out of your index entirely).

Essentially, if you are invested in a highly diversified global index fund and it is like having a net or a filtering mechanism that catches all the smaller companies on their way up to the big time but lets through all the rubbish as they shrink to nothing.

Sure you’ll miss out on some of the very initial growth, but believe me going from the smallest in a global index to the biggest will provide more than enough gains for most.

Take Ashmore Group for example. Right now Ashmore Group is worth about $2 billion. I’ve no idea what they do or care really. I just wanted get an idea of the size of a typical smaller company in the FTSE All World index. It was the first small UK company beginning with A that I found. I couldn’t be bothered to move on to the Bs so there are probably a few smaller companies than this in the index.

Anyway currently Ashmore Group is worth about $2 billion. It sound’s pretty big to me, but compare that to the biggest company in the index, Apple which is worth $2.5 trillion. That’s 1250 times as much! I think we can rest assured that that there’s plenty of growth potential there.