WHAT’S AN INDEX FUND & WHAT’S AN ETF?

Last week I posted a quick video from Fidelity that gave a nice overview of stocks and bonds for beginning investors.

I know a lot of people – beginning and advanced investors alike – have questions about index funds and ETFs (which, by the way, are great investment options for passive investors, especially when combined with a dollar-cost averaging strategy.)

So here are two short videos (2 minutes each) explaining what an index fund is and what an ETF is:

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And if you really want to get crazy, here’s a slightly longer explanation of ETFs from BlackRock (4 minutes):

In summary,

What is an index fund? A fund is simply a group of smaller investments you buy in a single package. An index is just a measure of a financial market. So an index fund is a fund that mirrors a certain index. For example, the S&P 500 Index measures the stock performance of the 500 biggest companies in the U.S. You can buy an S&P 500 index fund from firms like Vanguard, Fidelity, or Charles Schwab that tracks the S&P 500 – giving you exposure to the stock performance of the 500 biggest companies in the U.S.
What is an ETF? An ETF, or exchange traded fund, is a fund that trades on a stock exchange – just like the stock of Google or AT&T. As a consequence of being on an exchange, ETF’s offer more liquidity than index funds (you can buy and sell ETFs during the day; you can only buy and sell index funds at the end of the day), which is perhaps the biggest difference between index funds and ETFs.ETFs also offer lower minimum purchase requirements (you can buy as little as one share of an ETF; index funds sometimes have minimum purchase requirements of $3,000-$50,000 or more) and sometimes have lower expense ratios. There is also a more diverse universe of ETFs that you can choose from.

Should you choose an index fund or an ETF?

That decision really comes down to: (a) which index fund or ETF best represents the asset class you want to track (there may be plenty of index funds and ETFs that track the S&P 500, but you might have a tougher time finding an index fund than an ETF that tracks midstream oil companies), (b) which has a lower expense ratio, (c) what are the transaction costs involved, and (d) what are the tax implications.

Lastly, if you’re wondering what the best investment strategy is for “small investors who don’t have time to research individual companies“, I’ll leave you with this quote from Warren Buffett:

The best [strategy] in my view is to just buy a low-cost index fund and keep buying it regularly over time, because you’ll be buying into a wonderful industry, which in effect is all of American industry. If you buy it over time, you won’t buy at the bottom, but you won’t buy it all at the top either… People ought to sit back and relax and keep accumulating over time.

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Ben Graham, the father of value investing, wasn’t born in this century. Nor was he born in the last century. Benjamin Graham – born Benjamin Grossbaum – was born in London, England in 1894. He published the value investing bible Security Analysis in 1934, which was followed by the value investing New Testament The Intelligent Investor in 1949. Warren Buffett, the value investing messiah and Graham’s most famous and successful disciple, was born in 1930 and attended Graham’s classes at Columbia in 1950-51. And the not-so-prodigal son Charlie Munger even has Warren beat by six years – he was born in 1924. I’m not trying to give a history lesson here, but I find these dates very interesting. Value investing is an old strategy. It’s been around for a long time, long before the Capital Asset Pricing Model, long before the Black-Scholes Model, long before CLO’s, long before the founders of today’s hottest high-tech IPOs were even born. And yet people have very short term memories. Once a bull market gets some legs in it, the quest to get “the most money as quickly as possible” causes prices to get bid up. Human nature kicks in and dollar signs start appearing in people’s eyes. New methodologies are touted and fundamental principles are left in the rear view mirror. “Today is always the dawning of a new age. Things are different than they were yesterday. The world is changing and we must adapt.” Yes, all very true statements but the new and “fool-proof” methods and strategies and overleveraging and excess risk-taking only work when the economic environmental conditions allow them to work. Using the latest “fool-proof” investment strategy is like running around a thunderstorm with a lightning rod in your hand: if you’re unharmed after a while then it might seem like you’ve developed a method to avoid getting struck by lightning – but sooner or later you will get hit. And yet value investors are for the most part immune to the thunder and lightning. This isn’t at all to say that value investors never lose money, go bust, or suffer during recessions. However, by sticking to fundamentals and avoiding excessive risk-taking (i.e. dumb decisions), the collective value investor class seems to have much fewer examples of the spectacular crash-and-burn cases that often are found with investors’ who employ different strategies. As a result, value investors have historically outperformed other types of investors over the long term. And there is plenty of empirical evidence to back this up. Check this and this and this and this out. In fact, since 1926 value stocks have outperformed growth stocks by an average of four percentage points annually, according to the authoritative index compiled by finance professors Eugene Fama of the University of Chicago and Kenneth French of Dartmouth College. So, the value investing philosophy has endured for over 80 years and is the most consistently successful strategy that can be applied. And while hot stocks, over-leveraged portfolios, and the newest complicated financial strategies will come and go, making many wishful investors rich very quick and poor even quicker, value investing will quietly continue to help its adherents fatten their wallets. It will always endure and will always remain classically in fashion. In other words, value investing is vintage. Which explains half of this website’s name. As for the value part? The intention of this site is to explain, discuss, ask, learn, teach, and debate those topics and questions that I’ve always been most interested in, and hopefully that you’re most curious about, too. This includes: What is value investing? Value investing strategies Stock picks Company reviews Basic financial concepts Investor profiles Investment ideas Current events Economics Behavioral finance And, ultimately, ways to become a better investor I want to note the importance of the way I use value here. It’s not the simplistic definition of “low P/E” stocks that some financial services lazily use to classify investors, which the word “value” has recently morphed into meaning. To me, value investing equates to the term “Intelligent Investing,” as described by Ben Graham. Intelligent investing involves analyzing a company’s fundamentals and can be characterized by an intense focus on a stock’s price, it’s intrinsic value, and the very important ratio between the two. This is value investing as the term was originally meant to be used decades ago, and is the only way it should be used today. So without much further ado, it’s my very good honor to meet you and you may call me…