Traditional IRA

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Index and Exchange Trade Funds (ETFs)

by Donn J. Sinclair, MBA      March 10, 2020

An Index Fund is made up of a basket of securities designed to track and match the performance of a benchmark or index.  The Index Fund is also frequently called a Passively Managed Fund.  The Index Fund may be designed to track or match a stock or bond index.  Some of the most popular stock Index Funds attempt to track the S&P500 and the NASDAQ100, and some of the most popular bond Index Funds are designed to match the Total Bond Index and the International Bond Index.

Index/Passively Managed Funds are essentially the opposite of Actively Managed Funds.  These Actively Managed Funds attempt to beat the market return by employing a management team that hand picks a basket of stocks and/or bonds to outperform their target index or benchmark.  This Actively Managed strategy requires the expense of a larger  management team plus significant research and analysis expenses.  

Index/Passively Managed Funds do not have the above listed Actively Managed Funds’ expenses.  This Index Fund cost advantage is very significant over the years, and may help explain the tendency for Index Funds to regularly outperform their Actively Managed Fund rivals. The corresponding disadvantage for the Index/Passively Managed is the lack of reactive ability for protection in a trending down market.  

 A second core Index Fund advantage over Actively Managed Funds is that Index Funds tend to be lower-risk options for investing in stocks and bonds, and are designed for steady long-term growth.  Index Funds by design are well diversified which helps protect against deep losses. The corresponding downside is that Index/Passively Managed Funds lack the opportunity for large gains that would outperform their target index.

Transparency is another Index/Passively Managed Fund advantage – you know exactly how your funds will be invested.  This makes it easier to track your investment performance with the target index.  You may have several investment accounts; such as, a 401(k), Roth IRA, or TOD investment account.  Since you know exactly what is in your index funds, then it is easier for you or your advisor to complement your various investments accounts.  

The Indexed Exchange Traded Fund (ETF)

Index/Passively Managed Exchange Traded Funds (ETFs) have become highly favored investment vehicles in recent years.  These Indexed ETFs built upon the advantages of their mutual index fund cousins, and offer several distinct enhancements.  On average Indexed ETFs may be even more tax efficient than similar mutual funds, plus the Indexed ETFs frequently offer lower fees and expenses.  Another distinct advantage is that Indexed ETFs typically have more flexible trading schedules than indexed mutual funds.    

ETFs normally boast two distinct tax advantages versus Actively Managed and Indexed Mutual Funds.  Both of these mutual funds normally generate more capital gains taxes than Indexed ETFs.  Of note also is that ETF capital gains are only incurred upon a sale; whereas, traditional mutual funds normally pass on capital gains throughout the investor’s ownership.  Frequently traditional mutual funds will report capital gains distributions even when the investor has not sold any shares that year.  

Indexed ETFs may have a tax downside to traditional mutual funds.  When Indexed ETF dividends are distributed within 60 days of the investor’s purchase, then those Indexed ETF dividends will be taxed at the investor’s current income tax rate.  Of course for Indexed ETF IRAs, these tax differences are of little concern.              

Indexed ETFs may be purchased through the market day as compared to traditional mutual funds that may only be bought or sold once per day.  The traditional mutual fund purchase or sale must be placed while the market is open, and then that purchase or sale occurs after the market close.  This transaction delay may result in a significant price difference between the order and transaction prices.  For long-term investors this Indexed ETF intra-day trading flexibility should not be nearly as important; as this flexibility may be for those investors that trade more frequently.  Another consideration is that the Indexed ETF trading flexibility may also incur higher trading costs than most traditional mutual funds.

Probably the most important advantage Indexed ETFs hold over traditional mutual funds are the lower Indexed ETF fees and expenses.  Over the years lower cost investments have tended to outperform those with higher expenses.  These costs exist at some level for all ETFs and traditional mutual funds, and these costs include management fees, custody costs, administrative expenses, marketing expenses, and distribution costs.  

Indexed ETF investment costs are typically much leaner than their traditional mutual fund counterparts.  Frequently Indexed ETFs do not staff a call center for individual investor inquiries, and tend to have lower direct investor communication, marketing, and distribution costs.  Plus, normally Indexed ETFs have no short-term redemption fees.

Important Indexed ETF Considerations

A few words about risks, fees and expenses related to your investments. Before you move forward with any investment, be it Indexed ETFs or otherwise – you should carefully consider that investment’s objectives, risks, fees, and expenses. Not all exchange trade funds (ETFs) and traditional mutual funds may be appropriate for your specific situation. We all have our own unique risk temperaments and investment objectives that may or may not match any particular ETF or traditional mutual fund.  Furthermore, before investing in any ETF or traditional mutual fund you should carefully read the prospectus or summary prospectus.  This prospectus will outline the specifics of that fund; including that fund’s objectives, fees, and expenses.  Said securities expressly to include ETFs and traditional mutual funds.  Remember that any investment’s past performance is no guarantee of future results. The information and opinions contained herein are for educational purposes only; and expressly do not constitute a solicitation for the purchase or sale of any securities.  This educational information should not be relied upon as financial advice.

Updated in Rock Hill SC   March 10, 2020

Donn J. Sinclair, Winthrop MBA

Office (803)329-0609

Fax Line (803)327-4352

@Sinclair Financial Solutions is independently owned and operated.  Donn J. Sinclair, MBA is insurance licensed in NC & SC (NIPR NPN#1722815).  Investment Advisory Services offered through Prosperity Wealth Management, Inc., 2333 San Ramon Valley Boulevard, Suite #200 – San Ramon, CA 94583.  Securities offered through Fortune Financial Services, Inc., 3582 Brodhead Road, Suite #202 – Monaca, PA 15061; branch office of record located at 948 Myrtle Drive Rock Hill, SC 29730, Member FINRA/SIPC.  Sinclair Financial Solutions, Prosperity Wealth Management, and Fortune Financial Services, Inc are separate entities.   SC Real Estate License #76530, and NRDS #554027312.

 

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