Is an “Exchange Traded Fund” and a “Unit Trust Index Tracker Fund” also just the same thing with a different name?
Let’s clear this confusion up.
Luckily, I can talk about Index Trackers ALL day because these are some of my favorite things to invest in.
If you aren’t yet investing in them, go here to download a free guide to Investing with Index Trackers .
Index trackers are these juicy, amazing investment vehicles.
The easiest, lowest cost way for you to own and control an amazing selection of shares in companies all over the world – so your money gets working for you and not for the financial industry.
One of the most frequent questions I get asked about index trackers is this…
“Ann, what is the difference between an ETF, an exchange traded fund and a unit trust / mutual fund index tracker?”
This is a super question and something that really gets people stuck.
In this video, I unpack the difference so in no time you can move forward and know which of these two types of index trackers you should be using in your investments and why.
What is an Index Tracker Fund?
An index tracker fund is like a basket with a collection of shares in companies in the basket.
Actually, that’s just a description of an investment fund.
What makes something an index tracker fund, is how the shares that go into the basket are selected.
Index Tracker funds seek to replicate the holdings (the shares in the basket) and performance of a specific market index. That means that the shares inside a tracker funds basket are selected on the basis of the market index the fund is replicating and not based on a fund managers selection.
Investing in index tracker funds is also called passive investing.
Initially, index funds were introduced to provide investors a low cost investment vehicle that allows for exposure to the many shares included in a market index.
The primary advantage of passive investing using index tracker funds is the lower expense ratio (lower ongoing charges) of an index fund and the fact that the majority of investment fund managers fail to beat broad market indexes on a consistent basis. In plain english, tracker funds outperform most actively managed funds.
Popular indexes for U.S. market exposure include the S&P 500, Dow Jones Industrial Average and the Nasdaq Composite, for UK market exposure it’s the FTSE, for Europe, it’s the Eurostoxx, Hong Kong it’s the Hang Seng, for Australia it’s the ASX and so on.
Now you know what an index tracker fund is, how do you invest in them.
How Do You Invest In Index Tracker Funds?
The first thing you need to do is to set up an account on an online broker platform. Go here to learn how to select your online broker.
Once you’ve got your account open, you’ll decide on the portfolio you want (i.e the different markets you want to track) and you may even already know that you want a home market tracker or you want a develop market tracker or an emerging market tracker, and then you see there are two primary types of funds to choose from. You’ll need to decide what type of index tracker fund to invest in.
What Type of Index Tracker Fund Should You Choose?
Your choice will be investing in an ETF, an “Exchange Traded Funds” or a Unit Trust Fund (also called a Mutual Fund).
What the bleep is the difference?
Both unit trust / mutual funds and ETFs hold portfolios of stocks and/or bonds and occasionally something more exotic, like precious metals or commodities, or even some property.
Both unit trust / mutual funds and ETFs must adhere to the same regulations covering what they can own, how much can be invested in any one share and how much money they can borrow in relation to the portfolio size, and more.
Beyond these requirements, their paths go different ways.
Understanding an ETF
As the name suggests, ETFs (Exchange Traded Funds) trade on exchanges (stock markets), just as shares in individual listed companies are traded.
You can buy and sell ETFs at any point during a trading day at whatever the price is at the moment of the trade, based on market conditions, not just at the end of the day.
Index-tracking ETFs often have lower ongoing expenses (called Ongoing Charges or Total Expense Ratios TER) than index-tracking unit trust / mutual funds. In large markets like the UK and the US, this difference is rapidly closing, but elsewhere like Europe, South Africa, Australia etc, ETFs still have the advantage of lower ongoing costs. This means more of your money works for you and less goes to the financial industry.
This cost differential relates to the mechanics of running the two kinds of index tracking funds and the relationships between funds and their shareholders. In an ETF, because buyers and sellers are doing business with one another via the exchange, the fund house and its managers have far less to do.
The ETF providers, however, want the price of the ETF (set by trades within the day) to align as closely as possible to the net asset value of the index. To do this, they adjust the supply of shares by creating new shares or redeeming old shares. Price too high? ETF providers will create more supply to bring it back down. All of this can be executed with a computer program, untouched by human hands.
The ETF structure results in more tax efficiency, too. Investors in ETFs and unit trust / mutual funds are taxed each year based on the gains and losses incurred within the portfolios, but ETFs engage in less internal trading, and less trading creates fewer taxable events (the creation and redemption mechanism of an ETF reduces the need for selling). So unless you invest through a tax deferred account like your retirement account, pension, superannuation, 401(k) etc or other tax-favored vehicles like an ISA, TFSA, ROTH etc, your unit trust / mutual funds will distribute taxable gains to you, even if you simply held the shares. Meanwhile, with an all-ETF portfolio, the tax will generally be an issue only if and when you sell the shares.
Since ETFs are bought and sold on the exchange there are costs associated with the trade. These costs are once off costs you incur on the buy and the sell, but they can quickly eat into your investment especially when you are investing in small regular amounts. As a rule of thumb, only use ETFs when you are buying in lumps where the cost of the trade is less than 1% of your investment amount.
Some online brokers like Degiro in Europe offer a massive selection of trade free ETFs which enable you to do regular, smaller investment in ETFs as these costs are no longer a factor. And a platform like etfSA in South Africa, bundle the buying of ETFs for their investors to lower these trade costs.
The decision boils down to comparing the long-term benefit of lower ongoing charges to paying more upfront costs to enter into the investment.
Unit Trust / Mutual Fund
When you put money into a unit trust / mutual index tracker fund, the transaction is with the company that manages the fund. The Vanguards, HSBC’s, Fidelities, L&Gs and BlackRocks of the world – either directly or via your online broker.
The purchase of a unit trust / mutual fund is executed at the net asset value of the fund based on its price when the market closes that day or the next if you place your order after the close of the markets. When you sell your shares, the same process occurs, but in reverse. For long term investors (and that’s what we are) this doesn’t really make much of a difference.
Unit Trust / Mutual funds and ETFs are both open-ended. That means that the number of outstanding shares can be adjusted up or down in response to supply and demand.
When more money comes into and then goes out of a unit trust / mutual fund on a given day, the managers have to alleviate the imbalance by putting the extra money to work in the markets. If there’s a net outflow, they have to sell some holdings if there’s insufficient spare cash in the portfolio.
The Bottom Line
Given the differences between the two kinds of funds, which one is better for you?
It depends. Mostly it depends on the options available to you in your country and how much you’ll be investing with each trade.
Small regular investments in the UK and US – find a set of great unit trust / mutual index tracker funds with low ongoing charges or no trade cost ETFs, set up your automated regular investing and get on with your life.
Small regular investing in South Africa – find a platform like etfSA and use the bundled buying model of ETFs they use to benefit from low trade costs and low ongoing charges. Set up the automated regular investing and get on with your life.
Small regular investing in Europe, find an ETF platform like Degiro that offers you a great selection of no trade cost ETFs. Set up reminders for your regular investing and get on with your life.
For bigger lump sum investing, go with the same set you have for your regular investing.
Most of all, remember,
- being in the market is way more important than trying to time the market, and
- Consistent regular investing will always outperform haphazard investing.
In the comments below, I’d love to know:
- If you are investing in index trackers, what type are you investing in?
- If you aren’t investing yet, if you don’t yet have your regular stock market investing set up and your index tracker portfolios in place, tell me when you’re going to get started because you must have this juicy asset class working for you.
Remember, your freedom is created just one step at a time and that’s all you need to do. Keep taking that one step and let index trackers help you along your way.
With huge love
As you may have realised, when we invest in different asset classes we discover a whole new world, and with every new world, comes a whole new language, which is why I’ve also created a free Investment Jargon Buster for you.