The basic investment strategy is to save a small percentage of your income in each pay period and invest the money in a security that would grow over time. Index mutual funds have been a boon to investors who want to invest small amounts on a regular basis.
However, exchange traded funds (ETFs) are another way for investors to gain access to the market on a large scale without having to select specific stocks and are often a more cost-effective way to make periodic investments. Let’s look at the factors investors should consider when deciding between index funds or ETFs.
Comparing the costs of ETFs and investment funds
Both ETFs and index mutual funds let investors invest in many economic sectors around the world. Given the enormous and growing number of ETFs and index funds on the market, determining which sector or sectors have the most promise is critical. Once you have decided on the sectors you want to invest in, you can then narrow your search to specific ETFs or index funds.
Once you have identified potential ETFs and index funds that meet your investment objectives, compare the costs of those funds. There are several cost factors to consider; in most cases, ETFs occur in any case.
Cost ratios
Funds charge their clients fees based on a percentage of total assets under management (AUM). As a well-known cost ratio, this fee covers the fund’s overheads, such as fund managers’ salaries and all other operating and marketing expenses.
ETFs usually have a lower cost ratio because their operating costs are lower in design. Over time, this difference in cost, although small, may increase due to aggregation capacity.
Taxes
Your income will certainly be taxed. Index funds, especially actively managed funds, cause taxable events for their investors when they sell shares in their companies for profit, which can take place every year. As a fund owner, you will then have to pay capital gains taxes on all reported income. ETF investors will not receive capital gains until they sell the fund’s shares if they may be liable for the taxes they pay if the sale price is higher than their purchase price. This means that in the case of ETFs, you control the occurrence of a taxable event. When selling an index fund, investors must also pay capital gains tax if the fund’s value has increased.
Minimum investment
Most index funds require new investors to make a minimum investment in order to open an account. For example, a few Vanguard Index mutual funds have a minimum investment value of $ 3,000. Depending on the fund, the initial investment amount can be large. Many funds may charge a maintenance fee if investors do not maintain a certain level of investment. There isn’t a minimum investment amount for ETFs.
Fees and commissions
The main disadvantage of ETFs is the price of buying and selling shares. Remember that you buy and sell ETFs like stocks. Costs can vary significantly depending on the broker. When you invest $ 100 a month, you also pay the broker commissions and fees each month that hinder your earnings.
Index funds may not charge a fee for the purchase of their shares, even in small amounts, as long as you purchase them from the management company. That’s why your $ 100 monthly is invested in the fund. However, the fund will charge an annual management fee for the sale of the index fund’s shares. Other funds, like those sold through a broker, may incur a commission called a charge.
Bid-Ask Spread
When you buy or sell any share or ETF, there is a difference between the purchase price and the sale price, called the bid-ask spread. The higher the spread, the more the investment has to grow to overcome the higher purchase price and lower sale price. As with any stock, the spreads between ETFs depend on liquidity and trading volume. Widely traded ETFs have narrower spreads, while those that experience fewer trades can be large.
Moreover, purchase and sale prices vary during the day according to market movements. Like the purchase of shares, this momentary movement in purchase and sale prices may help acquire shares at a lower price. Of course, you can also buy ETF shares at a higher price on the closing day. When buying or selling ETFs, it is usually a good idea to use limit orders to give you control over your trading prices. Index funds are usually priced at the end of the day, which is the price investors have to pay if they decide to buy them.
Summing up
You must take a long-term perspective when making small periodic investments. First, decide which sector(s) you want to be exposed to. Choosing the right sector can significantly change the performance of your portfolio. The cost of your investment is the next significant consideration to make.
ETFs have lower costs involved than index funds, but the costs of buying and selling shares may increase as investors bear the transaction costs for each buy and/or sell order. These costs can reduce the overall return on investment. To reduce these transaction costs, investors should consider using a discount broker who does not charge a commission or, if possible, invest larger amounts less frequently once a year, perhaps quarterly rather than monthly.
You can also check these:
- For investors who want to save a little every month or every salary, exchange traded funds (ETFs) offer a cost-effective way to implement your strategy.
- ETFs are in many ways quite similar to index funds and are suitable for investors who have a relatively small amount to invest from time to time.
- Compared to index mutual funds, ETFs today are usually cheaper, more liquid, and more tax efficient.
Note: As more brokers switch to free commissions, ETFs have become an even more attractive way to make periodic investments.
