Index funds can be mutual funds that pools money from retail and institutional investors, or exchange traded funds (ETFs). The easiest way to understand an index fund is to visualise it as a photocopied binder of an original textbook. An index fund invests in almost the same investments in the same proportion of a well-known index in order to replicate the performance.
For example, you may have heard of the Dow Jones Industrial Average Index. It costs of 30 large US stocks. An index fund that tracks the DJIA would own all 30 stocks in roughly the same proportion. Likewise, an index fund that tracks the well-known S&P 500 index would invest in all 500 components.
What’s the difference between mutual funds and exchange traded funds?
An index fund could track either a mutual fund, or an ETF.
Both mutual funds and ETFs are pools, or baskets of investments such as stocks, bonds, and so on. But there are some key differences between the two.
|Mutual funds||Exchange traded funds|
|Price fluidity||Purchased or sold at the end of the trading day after the market closes||Traded like common stock, so prices of ETFs change as they are bought and sold|
|Transparency||Less transparent, holdings are disclosed on a quarterly or semi-annual basis||More transparent, holdings are disclosed daily|
|Fees||Higher fees than ETFs||Lower fees than mutual fund shares|
|Initial investment||High initial investment requirements||Low minimum investment, as low as one single share|
|Management||Usually actively managed by a fund manager, although there are some passive index mutual funds||Most ETFs track market indices and are passively managed|
Given the low minimum investment requirements of ETFs, they are the more popular choice for individual investors like you and I.
Exchange Traded Funds (ETFs) in Singapore
Exchange traded funds (ETFs), or “tracker funds”, are a form of passive investment. Like mutual funds, ETFs work by pooling all the investors’ money to buy a mixed bag of stocks. The returns from an ETF mirror the returns from a particular index.
For example, say you have an ETF that tracks the Straits Times Index (STI). If the STI is up 7%, your returns are also around 7%. Simple.
Of course, don’t just take the share price at face value. you have to take into account brokerage fees, the Net Asset Value, and other expenses.
The Net Asset Value (NAV) is the net value of an entity, calculated by taking the total value of the entity’s assets minus its total liabilities. NAV represents the per share/unit price of the fund on a specific date or time.
Mutual funds in Singapore
One key difference between mutual funds and ETFs is that the fees are not that transparent, and can add up taking up a huge chunk of your returns. Aside to brokerage fees, there may be wrap fees, switch fees, redemption fees, upfront sales fees, commission to the distributor, and so on.
Mutual funds are also usually actively managed by a fund manager, which means that there is a possibility that the investments chosen may be higher risk, since fund managers may be gunning for higher returns.
With mutual funds, you won’t be able to trade within each trading day as mutual funds are purchased or sold at the end of each trading day at the end-day NAV (price of the units).
Why should I invest in ETFs?
There are several reasons why you should choose ETFs over mutual funds.
1. Lower Expense Ratio
Most mutual funds are actively managed. They have a fund manager making decisions on which stocks in the fund to buy and sell, based on the reports of the financial analyst.
Whether or not these managers make the right decisions, they still need to get paid. And when they perform exceptionally well, they of course deserve a bonus.
Guess where the money comes from.
Right. The Total Expense Ratio (TER) of a mutual fund is what you’re being charged. Besides fund managers, the TER also pays for office space, and administrative staff.
The higher the TER (it’s often around 2%), the better a fund needs to perform to earn your returns. If your mutual fund generates 7% in returns, but the TER is 2%, you end up with 5%. If the fund does badly and returns are 2%… you see where this is going.
ETFs tend to have lower TERs than actively managed mutual funds – sometimes as low as 0.5%. Even if the overall performance of the ETF winds up comparable to a mutual fund, you still get higher returns because of the lower fees:
Mutual fund with 7% returns, minus 2% TER = 5% returns
ETF with 7% returns, minus 0.5% TER = 6.5% returns
This also means that you can start buying ETFs with fairly low capital (as little as a $1,000, depending on the going rate at the time).
2. ETFs are passive, low-stress investments
ETFs are passive investments. You buy them for the long term and slowly accumulate returns. Short term fluctuations in the market aren’t a worry, because the value of your ETFs will climb back up in time.
This makes ETFs the ultimate product for lay investors – you don’t need to check on your stocks every day, read charts, or worry about timing the market. And unlike stock traders, you will only drink alcohol for fun.
You could even invest in ETFs using a Regular Savings Plan that you can start with DBS, OCBC, POSB, Maybank or Philip Capital.
3. ETFs have proven relatively better performance
Most mutual funds don’t outperform the market. Some might, but it’s estimated that about 50 – 80% of fund managers will fail to do so (and 100% will promise otherwise).
Now, since ETFs track the market and provide equivalent returns, it also means ETFs often outperform mutual funds.
In Singapore, the Straits Times Index fund has delivered annualised returns of as high as 9%. Compare that to many local mutual funds, which consider 7% to be optimistic.
4. Easy diversification
You don’t want all your stocks to be closely interrelated. When 90% of your portfolio is related to, say, agriculture, a single tornado might wipe out years of accumulated wealth.
For safety’s sake, you need your stocks to be spread across a range of different sectors.
Say you want to buy a little bit of every stock: you’d need to research all the different companies you’re buying, most of which you won’t understand. You’d then need to work out whether you’ve diversified too much (resulting in poor returns), or too little (the risks are still too high).
Or perhaps, you want to obtain bonds. You can get ETFs that track bond indexes to allocate your investment funds in that direction.
You also may be interested in investing in another country, such as Bangladesh or Pakistan. There are roughly a hundred ETFs on the Singapore Exchange that you can buy to do so in a relatively low-risk way.
If you just buy units in an ETF though, you automatically diversify among all the stocks in the fund.
5. Less likely to blow up
Fund managers are inclined to take risks with your money. The higher risk they take, the possibility of higher returns, and, it’s not their money after all.
They’d assume you understand that losses are part of risks.
There is a small chance that the extra risk will result in a financial meltdown of epic proportions (see: Lehman Brothers).
With ETFs, this is less likely to happen. The fund simply tracks what the market is doing, and provides a proportionate return. It’s not trying to beat the market, so the only risks you face are threats to the market as a whole.
And if something can threaten the market as a whole, mutual funds are probably just as badly affected. So ETFs still trump in that regard.
What do you think of index funds like mutual funds and ETFs? Comment and let us know!
The post Singapore Index Funds (Mutual Funds or ETFs): Why Would You Want One? appeared first on the MoneySmart blog.
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