ETFs and index funds are investment vehicles that provide access to a group of investments. ETF stands for exchange-traded fund, marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund.
An index mutual fund can be either actively managed or indexed. Index investing has traditionally been the purview of the wealthy because it requires large minimum investment amounts and carries high management fees.
These restrictions do not apply to similarly behaving ETFs because they trade on exchanges just like individual stocks and therefore have low minimum investment requirements as well as low expense ratios.
Today there is almost $4 trillion invested in ETFs compared with about $1 trillion 15 years ago. This explosive growth shows no signs of slowing down because more and more people are looking into efficient ways of investing their money.
Passive index funds
ETFs are often called “passive index funds” because they track the performance of an index without attempting to outperform it. On the other hand, index funds are traditionally called “active mutual funds” because they attempt to do better than the index by actively picking stocks.
Although this distinction between active and passive is accurate, it can be misleading because most ETFs implement a form of market timing whether they advertise themselves as doing so or not.
For example, some ETFs hold stocks for short periods to avoid incurring taxable gains that affect their share price. Others engage in securities lending, which exposes them to different assets outside of those, including the index.
Tax efficiency is a significant factor in explaining why ETFs have become so popular because of their favourable tax treatment. Most dividends and capital gains do not get passed onto the ETFs’ investors but go directly back to the originating company or mutual fund.
Long-term investors can defer taxes indefinitely, which is impossible with actively managed funds that must realize gains regularly through turnover.
Furthermore, intraday trading allows for the intra-day realization of capital gains without impacting the fund’s share price, which means that capital losses can be used against realized gains from other activities, whereas this cannot happen with non-traded assets like real estate.
Lastly, ETFs are structured so that they can potentially offer more efficient tax-loss harvesting, which is a process that takes advantage of market movements to offset gains and losses.
ETFs are also more flexible than index funds because they can be traded easily throughout the day, like stocks. It gives investors more liquidity which can help diversify risk and reduce trading costs over time.
Finally, ETFs tend to be passively managed through futures contracts and swaps, which leads to lower costs for maintaining the fund’s assets compared with actively managed mutual funds.
These factors have made ETFs extremely popular and allowed them to outperform most active mutual funds over time despite their higher turnover and tax inefficiencies.
ETFs offers convenience, low expense ratios, and tax efficiency have appealed to individual investors and financial institutions such as pension plans and banks that are restricted in their ability to trade mutual funds after hours.
Even some firms that used to rely on commissioned stockbrokers have turned to ETFs because they offer passive investment strategies, lower costs, and the ability to scale up to more quickly than buying individual stocks.
The popularity of ETFs among institutions like pension plans stems from the fact that they can be part of a well-diversified portfolio while still maintaining liquidity for meeting obligations.
Large investors like state and municipal retirement systems need to invest beyond their fiscal horizon of thirty years or more while making regular contributions every year.
It even became possible for government entities such as Freddie Mac and Fannie Mae (which required congressional approval) to use ETFs for hedging and trading despite concerns that they might interfere with market-making activities in the secondary market.