EFTs vs. Index Funds vs. Active Investing

To help you build the best possible portfolio for yourself, here’s a closer look at EFTs (exchange-traded funds), index funds, and active investing. Each of these investment opportunities has its benefits and drawbacks, and knowing the differences between them will help you create a profitable and diverse portfolio. Before you dive headfirst into trading, it’s important to learn as much as you possibly can.

The Key to Success is Knowledge

Knowledge is power, and it’s especially powerful in the realms of trading. A thorough education in trading can lessen your risks; trading risks are an undeniable reality. Your investments aren’t guaranteed, and it’s possible to lose money, but if you’ve received training from real experts you’re in a better position to mitigate your risk. Before hazarding any of your hard earned money, get an education in trading from real traders who provide actionable, in-depth market analysis.

EFTs VS Index Funds

ETFs – or exchange traded funds – are often confused with mutual funds, because the two are so similar. But while mutual funds function like unit investments, where you can purchase a specific amount based on day end pricing, ETFs trade like stocks. That is, the price of an ETF varies throughout the day, based on buying and selling activity.

EFTs vs. Index Funds vs. Active Investing
EFTs vs. Index Funds vs. Active Investing

ETF’s are often favored with institutional investors, and particularly robo advisors. This is because they have lower fees than mutual funds. For example, mutual funds often charge load fees of between 1% and 3% of the amount of the mutual fund purchased or sold. A load fee can be charged either at purchase, on sale, or both. With ETF’s you don’t have load fees. You can usually purchase ETF’s for a flat commission rate that is typical of that charged for individual stocks. With many well known brokers, that commission will be between $7 and $10 per trade, which is extremely low when purchasing a large position in an ETF.

Index funds are typically ETF’s, because ETF’s are a more compatible structure for index funds than mutual funds are. Index funds are tied to an underlying index, which they duplicate through investment activity. The S&P 500 is the most common index, but there also indexes available for various market sectors, including technology, healthcare, energy, individual countries, or even continents.

Because the fund tracks an index, it only trades securities when the stock composition of the given index changes. That means that index funds are considered to be passsive investment vehicles. This is in contrast to mutual funds, which are typically actively traded funds that seek to outperform the market. Since passive investing generates fewer fees than active trading, this is another reason why ETF’s, especially index funds, have lower expenses than mutual funds.

EFTs are extremely popular with active traders and hedge fund traders. This is because EFTs are flexible and convenient. They require little more than your financial investment, and there’s no rollover costs or margin, no special accounts needed, and no special documentation required. There is less of a “cash drag” with these funds, as the transaction costs are very low and there’s no cost for holding cash.

Index funds do have one clear advantage over non-index EFTs. The dividends earned are paid immediately, while non-index EFTs don’t pay until the quarter ends. So, if you favor having your dividends paid to you right away, index funds may be a more logical choice. Otherwise you can diversify your portfolio by favoring EFTs, but leaving room for some index funds which may see profits sooner.

Do You Have the Time For Active Investing?

We just discussed how active investing is an attempt to outperform the market. That involves buying and selling various stocks at hopefully opportune moments. Active investing can also vary as a matter of degree. When it comes to mutual funds, that degree is determined by portfolio turnover. That’s the percentage of the portfolio that is traded in a given year. For example, one actively traded mutual fund may experience 80% portfolio turnover, while another may have 160%.

Non-index EFTs are a bit like active investments because they experience price changes throughout the day, but very active investing is when you seek out short-term profits, not long-term success. This isn’t typically the case for EFTs and certainly not index funds. Non-active investors hold onto their funds for a long while before they’re sold off – if ever. Active investors give their investments a huge time commitment, and watch them closely for those daily dips and gains and then sell them off when they’ve hit profitable conditions.

At the extreme end of active investing are day traders. They follow the market very closely each day, and attempt to exploit changes in stock prices as they occur, buying and selling them for razor thin profits. They experience both gains and losses, and if they are successful, the gains will generally exceed the losses.

Investment Diversification

It cannot be stressed enough the importance of a diverse portfolio. Before you jump into active investing and/or investing in EFTs and index funds, it’s important to educate yourself. Nothing can guarantee the success of your investments, but diversification means your eggs aren’t all in one basket. You can work toward your financial goals with less risk if you diversify, and if you’ve taken the time to learn all you can about investing you’re in an even better position.

While you may need to be primarily invested in stocks, it’s also important to have a certain percentage of your portfolio invested in non-risk investments. These are typically comprised of interest-bearing securities, such as certificates of deposit, U.S. Treasury bills, and money market funds. They will help to preserve your portfolio value at times when stocks are falling.

A good mix includes a percentage of your portfolio in safe investments, with the largest share dedicated to passively managed stocks investments, such as index funds. Then a minority of your portfolio can be invested in actively traded investments, such as mutual funds and individual stocks, and – if you so choose – day trading.

That mix should give you a healthy blend of safety and performance over the long-term.

( Photo by Butz2013 )

2 Responses to EFTs vs. Index Funds vs. Active Investing

  1. Thanks for the article, Laura. This was a great summary. I’m a big fan of ETFs for most of the reasons you listed (particularly liquidity compared to mutual funds). Thanks again for the great post!

  2. Hi Jay – I think that ETFs need to make up the core of the average investor’s portfolio. That doesn’t mean not holding other asset types and classes, but more that the average person of course isn’t a professional investor, and needs to stay primarily with the assets that have the best performance potential with the least relative risk. Now for more sophisticated investors it can always go in another direction.

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