Index funds, exchange-traded funds and Christmas musings

It was my first time to spend Christmas in solitude. To be quite honest, it didn't make any significant difference. I tend to find ways to preoccupy myself that it didn't bother me at all whether I was with people or not. While I was gradually recovering from a disrupted sleeping pattern due to night shifts and making the best of myself to stay jolly and merry (and not sleepy) on Christmas day, I went through my head as to how can I explain an index fund and an exchange traded fund in a nut shell to a 10 years old kid. I guess that the topic is quite daunting to some and to talk about money in general seems to be a taboo which makes it challenging. Fortunately, I love challenges.

Let's start with what is an Index Fund? To put it simply, it refers to any funds that track a market index. Now, I bet the next question will be what is a Market Index? According to Investopedia, it is a hypothetical portfolio of investment holdings that represents a segment of the financial market. It means that it estimate or gauge the movement (or performance) of a certain market.

For example, if you want to invest in the U.S. market, one of the most popular index fund is the S&P 500 (Standard & Poor 500) which tracks the top 500 largest stocks (which includes companies such as Amazon, Microsoft, and Apple) in the U.S. Other popular stock indexes for tracking the performance of the U.S. market are DJIA (Dow Jones Industrial Average), which tracks the 30 large cap industrial stocks (which includes companies such as American Express, Boeing, and IBM) and NASDAQ-100 (Nasdaq Composite Index - 100), which tracks the 100 large cap technology stocks (which includes companies such as Amazon, Adobe, and Apple).

Aside from the U.S. market, a widely followed index fund is the MSCI EAFE (which stands for Morgan Stanley Capital International - Europe, Australia and the Far East), which follows the large cap stocks of developed countries across Europe, Australia and the Far East. With all of this variety of indices, it gives an investor an opportunity to gauge the performances of different sectors or industries and the economy as a whole.

An index fund includes both an index mutual fund and an index exchange-traded fund. Both of which uses a passive investing strategy with the objective of delivering returns similar to the index of investment. Moreover, an index fund can track different assets such as stocks, bonds, commodities and even currencies. It has a low expense ratio compared to actively managed funds.

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THINGS TO REMEMBER!

What is an Index Fund?

- any funds that track a market index (e.g. S&P 500)

- includes both an index mutual fund and an index exchange-traded fund

- uses a passive investing strategy

- track different assets such as stocks, bonds, commodities and even currencies

- has low expense ratio

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Now, I want to focus more on Index Exchange-Traded Funds (or commonly known as ETF). An ETF trades like a stock in the stock exchange, which means that it can be bought and traded all through out the day. Like other types of funds, an ETF pulls money from investors and invests it in stocks, bonds and other securities. Because it spreads the money in different securities, it provides the investor some diversification which helps balance risk. There are a variety of ETFs and each with different objectives. Some invest in a variety of stocks and bonds, some replicate the performance of a stock index (such as S&P 500), and some track the performance of a particular market sector (such as Tech or Pharmaceutical sectors). Also, other ETFs track assets such as corporate bonds, stocks in remote countries, commodities and currencies. These assets carry a unique risk but ETFs that tracks them offers a practical way to analyze it.

Let's put an example where in an investor wants to make a diversified investment that is designed to mirror the performance of a major stock index such as the S&P 500. After researching different ETFs and finding the one she wants based on her objectives, she purchases the share of it through her broker (e.g. Ameritrade, AJ Bell). Now that she own a share, the investor has a stake in each of the fund's variety of investment while only having to purchase one ETF. Participating in the wide market with only a single purchase instead of multiple purchases can save investor research and analysis time.

In addition to saving an investor's time from painstakingly analyzing and researching individual stocks, an ETF requires a lower minimum investment (and some brokers such as Robinhood offers fractional shares). Moreover, it also has lower management fees due to the fund is not actively managed (which translates a positive return in the long run as small fees become significant when it is added up).

So how do you earn a return from an ETF? There are two ways as how you will earn from an ETF. First is through a rising ETF price. For example, if an investor have bought a share of the ETF at $5 and the next year it grew its value and the price became $10. The investor will earn $5 if she sells her position. Second is through dividend. A dividend refers to a distribution of profit by a company to its investors (or shareholders). It is important to know how much dividend yield (shows how much a company pays out in dividends each year relative to its stock price) a fund has before purchasing.

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THINGS TO REMEMBER!

What is an Exchange-Traded Fund?

- it can be bought and traded all through out the day

- invests it in stocks, bonds and other securities

- provides the investor some diversification which helps balance risk

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Index Funds and Exchange-Traded Funds share many similarities. So what's the key differences between an Index Fund and an Exchange-Traded Fund?

• ETFs trades like a stock and can be bought through out the day while index funds could be traded once at market close.

• ETFs are often cheaper than index funds (if bought commission-free).

• Index funds often have higher minimum investments than ETFs.

Image A below provides a good summary of the differences between an index fund and an ETF.

Image A: Index Funds vs ETFS (photo credit to Motilal Oswal Asset Management)

My thoughts on this...

I have always liked simplicity in my life which in effect makes me more efficient in handling life's challenges.

In Timothy Ferriss' The 4-Hour Workweek, he says that “By working only when you are most effective, life is both more productive and more enjoyable. It's the perfect example of having your cake and eating it, too.”

Let's be practical in this matter about investing. I do not have enough time to spare on researching about individual stocks and trading positions every time there are fluctuations in the prices. Other than that, I am lazy (of course, in a good way!).

It is not that I am not a trader per se, I am just not interested in those fancy non-sense flat screens displaying stock market tickers that other people are into. I want a life as a I juggle between my work and other responsibilities. Hence, I prefer steady and long-term growth. Because of this, I have three requirements when choosing the right investment vehicle for me.

These three things are:

1. Diversified

2. Low expense ratio

3. and if possible, as passive as it can get!

An index fund and an exchange-traded fund satisfy my three requirements. Legendary investor Warren Buffet wrote in his 2016 Berkshire Hathaway annual shareholder letter, ''My regular recommendation has been a low-cost S&P 500 index fund''. Moreover, in his book ''The Little Book of Common Sense Investing'', he said that ''A low-cost index fund is the most sensible equity investment for the great majority of investors. By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals.''

Ultimately, it all comes down to personal preference and financial goals!