ETFs vs. Index Funds: Investing 101 w/ Doug Flynn, CFP

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Doug Flynn, CFP, of Flynn Zito Capital Management, LLC on ETFs vs. Index Funds.

Ali: Explain the difference between an ETF and a mutual fund…

Doug: Well an ETF is a mutual fund that you know and love, but it trades on the exchange, so you can buy throughout the day. Versus a traditional fund which trades once a day at the end of the day.

Ali: Okay, so let’s talk about index funds, which really came first. First you had stocks, then you had index funds.

Doug: Yes, an index fund is just trying to replicate a particular index, which you can’t invest in directly, but this is a way to replicate that. So if you like the stocks in the S&P 500, or the stocks in the Dow…

Ali: It used to be that you could just read about the stocks in the Dow or the S&P 500, and buy the individual stocks. If you wanted to, you could buy all thirty in the Dow…

Doug: That’s right.

Ali: But then, we came up with index funds, which said, “You can do the Dow, you can do the S&P 500, you can do the Nasdaq, you can do…I don’t know…Easter European industries.

Doug: Exactly, and that is going to track an index, there isn’t a lot of trading or active management in there. You can do that in a traditional mutual fund format or in an ETF, which is the exchange traded version of that, which just means it trades throughout the day.

Ali: Generally speaking, index brought the management fees, these fees associated with mutual funds, down, because there’s not somebody doing a lot of active work, and ETFs brought them down further.

Doug: Correct.

Ali: So why would I choose one vs. the other?

Doug: So if you buy an ETF, you’re typically placing a trade like a stock. So, if you’re with an online broker, they’re typically going to charge you some type of a trading fee to do that, whereas a mutual fund may have a minimum, but won’t necessarily have a transaction charge to do that. There are some cases where that isn’t the case.

Ali: If you’re doing this for fees, you better look at this and understand that you’re paying for trades.

Doug: Yeah. Most people are putting money away each month. You know, one hundred dollars per month is what they’re doing. You can’t really do that with an ETF because you’re making a transaction every single time. That’s where a mutual fund might be better.

Ali: So you’re putting one hundred bucks a month away, but you’re paying ten dollars for the transaction, you gotta weigh that in.

Doug: Maybe you use the index fund for a little while, and then you have $10,000, and then you can actually do those transactions. So that’s where you might want it in different ways. And that’s where it’s cheaper. Like anything else, the more money you have, it might be a little bit cheaper.

Ali: One thing you warn is not all ETFs are created equal. What do you mean by that?

Doug: Well as an example, the two major providers, there’s Vanguard, there’s i Shares, which are two different providers of ETFs. And you have to look at the structure. And the structure of i shares in particular, they’re completely separate, which means their tax ramifications are very low. They don’t necessarily pay capital gains to speak of because they’re just trading in and out of the ETF structure by itself: it’s a stand-alone ETF. Vanguard did what is kind of a bolt-on to its existing mutual funds. What’s happened there, is some cases, when the fund pays a capital gains distribution…

Ali: Because they sold a stock at a profit…

Doug: Right, a large institution wants to sell a bunch of their funds, it transfers into the ETF itself. So all ETFs are not created equal, and you should look at, if I want bond index ETFs, look a little bit deeper and look where are there capital gains distributions. Many people know there are these issues in traditional mutual funds that are actively managed. And they don’t scroll down and see if there are differences between the different ETF providers.

Ali: And of course that makes a difference depending on how you’re investing. Whether this is inside a tax-preferred investment, or it’s just out in the open.

Doug: If it’s an IRA it doesn’t really matter, but if it’s in a taxable accound, the last thing you want is further tax surprises you thought you were avoiding by being in ETF format.

Ali: This is a business for people who feel they’re not going to outperform the market with their own selections.

Doug: Exactly, you’ve said in a particular area I don’t think I can bring value, I can’t find a manager who will bring value in a particular are, I’m just going to index then. And as a portfolio manager and as people who manage money, there are times when we find that you can’t bring value with managers, and that they’re out of favor, and you might index more. But we’re agnostic.