We already covered what index investing is and how it can be done using index funds and ETFs. I will assume that you know what what they are and how they work, because the idea of this post is to help you decide which one to use for your portfolio.
So, in case you need to brush up your knowledge, read these first:
And of course, we will look at them through a passive investing perspective.
Assumptions
- You want to accumulate long-term wealth through index investing
- You know what index funds and ETFs are
- You defined an asset allocation of indices you want to track
Make sure that all three points are applicable to you, because learning about each additional topic simultaneously will make the process exponentially more complex.
Basically, this post is for those who have trouble deciding which product can facilitate their road to success.
What to choose? Index Fund or ETF?
I won’t beat around the bush, the only real answer is: it depends.
However, unlike many posts that promise to solve dilemmas which don’t have a clear answer, this one won’t leave you hanging with >2400 words read but no real value extracted. Basically, I’ll give you a structured approach on how to decide for yourself.
There is one single parameter that will determine how your portfolio will perform on the long run – the cost.
Why cost is so important?
Let’s take a look at two funds that yield the same returns, but one is more expensive than the other. Let’s say we’re investing $100k in a lump sum manner for a 20 year horizon, assume a 10% yearly return, and we will ignore taxes.
Fund 1
In the first fund, we pay 0,5% enter fee, 0,5% transaction fee, an ongoing 0,5% TER, and eventually, a 0,5% exit fee.
So, 100000$ – enter fee = 99500$
99500$ – transaction fee = 99000$
After 20 years, at 10% growth and 0,5% management expense per annum, the amount we end up is 602490$.
Lastly, we want to withdraw the amount, so we pay a 0,5% exit fee and we’re left with 599477$.
Fund 2
The other fund has no enter and exit fees, but just an unavoidable expense ratio of 0,1%.
The $100k after 20 years will be worth 659422$.
Conclusion
Fund fees are rarely high, especially in developed countries where the funds must offer competitive prices in order to keep their clients. However, even those 0,5% fees can make a drastic difference in your portfolio’s performance over the years. In the above example, they made a difference of $60k.
So once again, there is a single parameter that will determine how your portfolio will perform on the long run:
Costs.
Costs Breakdown
Investing is associated with various types of expenses – on the gains but also on the principal. These include but are not limited to:
- TER
- Enter and exit fees
- Transaction fee
- Broker fee
- Capital gains tax
- Dividend tax
Not all are associated with both products (ETFs and Index Funds), so let’s dissect where they’re applicable and how they can affect your portfolio.
Total Expense Ratio
This is a fee you can’t avoid. Whether you go with an index fund or an ETF, there will be an expense ratio.
However, the fact that you can’t avoid it makes it easier for the decision making process. Basically, find the lowest TER.
I’ve seen S&P 500 tracker funds that ask for 1% management fee, while on the other hand SPY (SPDR S&P 500 ETF) has 0,09%, IUSA (iShares Core S&P 500 UCITS ETF (Dist)), CSPX (iShares Core S&P 500 UCITS ETF (Acc)) and VUSA (Vanguard S&P 500 UCITS ETF) all have 0,07%, IVV (iShares Core S&P 500 ETF) has 0,04%, and VOO (Vanguard S&P 500 ETF) has 0,03%. Find the cheapest fund available to you.
Enter and exit fees
These fees are more common with mutual funds. The ETFs don’t have enter and exit fees because they’re bought on exchanges, same as shares.
Although it’s not common, have it in mind – if you see a number greater than 0,25% for enter / exit fees for a tracker fund, look the other way. When it comes to index investing, there are plenty of options where you won’t have to sacrifice such a big part of your portfolio, so try to find the cheapest options.
Of course, you can mitigate this costs by buying ETFs through a broker, but that doesn’t mean that their overall cost will be lower.
In summary, when you’re evaluating an index fund, make sure to account for both enter and exit fees.
Broker fees
Since the ETFs are listed on exchanges, we need a broker in order to trade them.
We, the investors, are how the brokers make money. We pay a commission for the privilege of being able to buy shares with a click of a button, knowing that our order will be placed and our trade settled.
Different brokers have different account fees. Some are yearly and some are monthly, some are a percentage of the investor’s portfolio and some are fixed.
Examples of two reputable brokers are DeGiro and Interactive Brokers. A standard account on DeGiro costs nothing, apart from a small fee for having shares on certain exchanges. On the other hand, Interactive Brokers costs 10$ per month, unless your portfolio is higher than $100k, in which case it also costs nothing.
My point is: neither is inherently better than the other, but the broker fees may vary based on your personal situation. Further research on the brokers’ pros & cons as well as your financial situation and needs will lead to answering this question. I don’t like being vague, so I’ll give you a plan for assessing brokers: find the most reputable options available to people in the country you reside in. Only then filter them out based on things like how much money you’re planning to invest, how often, where you live, which ETFs are available, etc.
Since you’ll need to do some work yourself, if you’re unsure about anything call them to get the answers with full transparency.
Transaction costs
These are one time costs associated with buy orders.
Both brokers and index funds may have transaction costs on the purchases. There is no rule that shows which one is lower, so see the fund you’d chose and the broker where the ETF of choice can be bought and compare their costs.
Coming back to the example of DeGiro, there is a transaction fee of 2% when buying shares and 1% for buying ETFs. However, they also have commission free ETFs which cost 0$ if bought once per calendar month. My portfolio is build from this list.
So, once again, get all your opportunities and account for this cost as well. Check the various types of account per platform because the trading costs can be different for different accounts. This is usually clearly stated on a pricing / costs page for each platform.
Capital gains tax
Same as with all the others, there is no one answer that fits universally as different tax laws apply in different countries.
Some have 30% capital gains tax (Sweden), some have 10% (Bulgaria), and some have 0% (Switzerland). In some countries it’s paid only when you sell, in others it’s paid on assumed gains throughout the year.
Make sure to understand how the gains are taxed in your country of residence, because this might have a huge impact on your decision. Some countries waive capital gains taxes if you’ve held your assets longer than a certain duration, so make sure to inform yourself about that as well.
If you’re living in a country where this information is not easily accessible, the safest route you can go is hiring a tax adviser for a one-time consulting session. If you’re from a first world country though, avoid this additional expense. All this information can be found online.
Let’s take a short break here.
I want to remind you to share this post on social media if you’re finding it valuable so far.
Also, subscribe to my newsletter if you still haven’t. You’ll get a mail each time I publish a new post.
Now, let’s continue.
Dividend tax
Same as with the capital gains tax, dividends are taxed differently in different countries. Not only that, but the way they will be taxed varies based on the product, the underlying companies, the fund’s domicile, your country of residence, etc.
Although dividend tax can become pretty difficult to optimize, the basic filter should be on accumulating vs distributing funds. So make sure to assess how dividends are taxed in your country and pick an accumulating fund if the capital gains would be taxed less. As you should already know, an accumulating fund reinvests the dividends instead of distributing them to investors. In some countries this may be beneficial, but in some it may not make a difference.
However, when it comes to dividends, the dividend tax in your country of residence is just a small piece of the puzzle. For international investors, there are also dividend leakage and double taxation.
Double taxation
Let’s say you’re a non-US person looking to invest using the S&P 500 as a benchmark.
So, you find an adequate (reputable & low cost) index fund in your country. This means that the following will happen:
- The companies will issue dividend, withholding US dividend tax
- The fund will receive the dividends and pay them out to you, withholding your country’s dividend tax
In other words, you’re taxed twice – once in the country paying out the dividends and once in your country. Some funds have ways to (partially) recover the taxed amount, so make sure to understand their process and include it in your calculations.
It’s similar with the ETFs: the issuing companies will withhold US dividend tax, but you’ll get the dividends in full in your brokerage account. During tax returns season, you’ll have to report the dividends to the tax authorities yourself. How much you’ll be taxed is based on where is the domicile of the ETF and the tax treaties between that country and your country of residence.
The double tax treaties can be easily checked by a quick Google search. This can make a huge difference if you’re investing through products out of your country.
Let me use myself as an example for optimizing this cost: I live in The Netherlands and invest in US companies through Ireland domiciled ETFs. The reason I do so is because Ireland withholds no dividend tax when paying dividends to non-residents, which means I get the full amount. On top of that, NL has a tax treaty with IE and doesn’t tax dividends from Irish domiciled funds.
In other words: I pay 0% dividend tax on the amount I receive.
If I went with a Dutch fund, this amount would’ve been 15% (the Dutch dividend withholding tax). Make sure to understand your country’s position relative to both the companies you’ll invest in but also the domicile of the products you’d use.
Dividend leakage
We discussed dividend leakage a lot in the previous section, but I wasn’t explicit about it.
So, we understood what happens when the dividends are paid out by the fund to you, but what about the US dividend tax being withheld when dividends are distributed initially?
Well, this is something that can’t really be mitigated easily. Even if you buy an accumulating ETF, that doesn’t mean that you’ll protect yourself from the dividend leakage. The reason for that is because accumulating ETFs reinvest the dividends instead of paying them to you. In other words: they receive the dividends from the underlying companies (with taxes withheld) and then proceed to reinvest them instead of paying them out to you. So you may protect yourself from not being taxed in your country, but the dividends themselves will be taxed when issued.
There is something that can be done though. I’ve seen both ETFs and brokers offering to recover half of these withheld taxes. I can’t talk about this in a global context because it depends on your country of residence and, again, the relationship between that country and the country that’s distributing the dividends. If applicable, you’ll need to fill out a form and they’ll take care of recovering the amount.
Make sure to contact both the funds and the brokers you’d use and ask them how they handle dividend leakage. But remember, having no dividend leakage doesn’t mean that that option costs less. You need to understand it in the greater context of dividend taxes and only then use the amount in the even greater context of all expenses.
I know all of this seems too complicated at first, and I’m sorry about that, but give it some time. It becomes second nature after a couple of months.
FX costs
And lastly, there are the foreign exchange costs.
If you’re investing in EUR but owning US distributing ETFs, you will get your dividends in USD. If you go through an index fund in your country, you might get the dividends directly in your currency. Make sure to understand what conversion rates are used by your broker and also if there is a fee when converting.
In case you want to take care of it yourself, checkout TransferWise. It’s a money transfer service offering the lowest FX rates I’ve seen so far. I have a detailed review and introduction to the platform in this post.
Bottom Line
So, what should you pick: index funds or ETFs? It doesn’t matter,
Put all your options that make sense in one basket and filter most of them out by their management fees (TER, MER). Discard all above a certain threshold and continue comparing the ones lefts. Account for enter / exit fees and also for transaction fees. If you need a brokerage account, include the broker’s fee in the calculation. If applicable, consider only those with the dividend distribution policy that makes sense (for example, pick accumulating funds in countries with high dividend taxes). And then account for capital gains and dividend taxes. Lastly, check out the FX costs and the tax treaties where applicable.
If you’re left with 2 things you can’t make your mind about, just pick one.
When you know what to look for, the decision making process becomes structured and much easier.
Have in mind: some costs are unavoidable. There will be an expense, regardless of what you do, so don’t be afraid of it. The goal is to find the best opportunity – the cheapest one. Some people told me that they’re not investing because they’ll have to pay capital gains taxes on the profits. I won’t dishonor MonkWealth by addressing this argument on it. I’ll just say that learning about opportunity cost won’t hurt. Not considering it when evaluating costs will.
Summary
List all the products available to you, regardless if they’re index funds or ETFs, and sum all the costs per product. Order the list by total expense in ascending order and pick the first element.
PayPal.me/MonkWealth