“Most of the mutual fund investments I have are index funds.”
- Charles Schwab, Guide to Financial Independence

Chapter 6: EXCHANGE TRADED FUNDS: WHAT ARE THEY AND WHY SHOULD I CARE?

Tax saving

“Investing is a science, not an art. The challenge is to adhere to the proven science of investing which works – and to overcome your compelling investment instincts that will invariably lead you astray.”
- Rip Van Winkle Wisdom

By Selwyn Gerber:

Payroll tax problems

Exchange Traded Funds (ETFs) are the most efficient, liquid and tax efficient vehicle for index based investing. They take the elegance and superior returns of the traditional index fund to the next level by packaging indexes in freely traded securities that trade just like stocks.

ETFs are a relatively recent creation of Wall Street. They are essentially baskets of stocks that trade together as one security. The vast majority of ETFs are passive index vehicles, designed to contain a predefined basket of securities. While actively managed ETFs are beginning to gain notice in the marketplace, they remain a small piece of the ETF universe. The most notable differences between these investments and mutual funds are that index funds trade only at the end of the day, while ETFs trade continuously. Moreover ETFs can be sold short and are optionable, meaning speculators can place bets on future price movements without purchasing the ETF directly.

Payroll tax

For Rip Van Winkle types index funds are an excellent investment vehicle, but ETFs are superior in many ways and make a good idea even better. ETFs offer lower costs and greater tax efficiency by eliminating the sometimes sizable phantom income taxes that can be created by mutual funds. It is well known that an investor could purchase mutual funds late in December and receive a tax notification of realized taxable gains on that investment even though he did not earn a penny or trade after the acquisition. ETFs on the other hand pass through virtually no income tax to the investor. These and other advantages make ETFs ideal for long term investing.

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“Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”
- William F. Sharper, Nobel Laureate in Economics

There have been many articles written comparing ETFs to index funds, but most have been prepared by companies with an interest in the outcome of the debate. Mutual fund companies are able to show that index funds are a better investment than ETFs. Not surprisingly, ETF sponsors build a strong case for the superiority of index-based ETFs.

A large number of passive institutional investors prefer ETFs for their flexibility. Many prefer to use ETFs to hedge their stock market exposure instead of using more expensive futures and derivative contracts. Another advantage is that ETFs can be purchased in smaller sizes than derivatives. They also don't require special accounts, rollover costs or margin. Additionally, some ETFs cover benchmarks where there are no futures contracts.

Active traders, including hedge funds, trade ETFs for their convenience, because they can be traded as easily as stocks. This means they have margin and trading flexibility that is unmatched by index mutual funds.

Passive retail investors, for their part, often prefer index funds for their simplicity. Investors do not need a brokerage account to buy and hold index funds. They can often be purchased through the investor's bank. This keeps things simple for investors. The reality is that a brokerage account is no more difficult to open than a bank account and the brokerage account often includes features that would benefit the individual. Margin, when properly used, can provide financial flexibility, for example.

One of the original reasons for the creation of index funds was to lower the costs of investing. Bogle’s vision for the funds was to almost match the market indexes, lagging by a very small amount due to fund expenses. The investment community uses the term “index tracking” to describe how closely the mutual fund or ETF comes to matching the performance of the benchmark index.