Indexed Mutual Funds Vs. Indexed ETFs

Indexed products have seen tremendous growth over the past few years.  More and more intelligent financial people are recommending it as individuals primary form of investing over actively managed funds.  The concept is to reduce the fees you pay, resulting in a higher return, which over the course of your investment lifetime, will result in substantially more money for the investor.  Both of these products track the same indexes and offer similar returns, so that begs the question which should you invest in?  To answer that first let’s define the two options and discuss the key differences.

Money Mangement

What are Index Mutual Funds and Indexed ETFs?

 

Both indexed mutual funds and indexed EFTs are both really similar in that their goal is to offer the same return as whatever index they are tracking.  The main difference is the makeup of their fee structure.  With a mutual fund, there will be a higher MER (management expense ratio), however there should be no fee when you purchase the fund.

On the flip side, an EFT has a much lower MER but is treated as a stock, where you pay commissions when you buy and sell it.

Which Should You Purchase?

 

Based on the above analysis you can create a simple breakeven equation to determine which is the optimal to buy.  The MER acts as the x variable (output is determined by the input amount) where the commission costs (buying commission plus the discounted selling commission) acts as the y variable.  You can then determine your breakeven point where you will be indifferent on a mutual fund or ETF.

Generally speaking, the average person will want to be invested in both.  Most people should be set up with an automatic purchase plan where a percentage of their pay will come off and be invested.  At this point a mutual fund will make more sense.  It isn’t going to be a large amount so the commissions are going to be much higher than any savings from a lower MER.  Then once the fund reaches your breakeven point you should switch over to EFTs (assuming you have held the investment long enough that you do not pay backend fees.  If so then wait until this time period has expired).

Using this strategy will result in the least amount of fees paid, maximizing your savings!

 

Something to Note

 

EFTs are technically a stock and have stock principles.  The main one of note here is supply and demand principles.  There is a case to be made that when you are closing in on retirement that switching back to mutual fund is worth the small amount of money you will give up due to the higher MER.  The case would be that in the event of a market crash, it might be tough to cash in the ETFs or you will have to do so under market value (large supply no demand lowers price than the value of the underlying asset if investors are concerned about market tanking).  In a mutual fund the value of the share will always be the value of the underlying assets.

 

 

 

 

Start Saving Young

save your money

One of the most power financial tools at a person’s disposal is compounding interest.  In order to gain the full power of this tool, you need to start saving as soon as possible!  Here’s an example to show the power:

If you start saving $500/year at the age of 25, by the time you retire at the age 65 it will be worth (assuming a 6% average ROI) just over $77, 000.  If you were to start just 5 years later, it will be worth just under $56,000.

That’s a crazy difference! The difference in the money the individual invests is $2,500 yet the total difference is $21,000.  Who wouldn’t want this!

This shows the power of compound interest and why you need to start saving as soon as possible.  The later you start, the more of your own money that you have to work hard for needs to be contributed.

Now, why do people start so late saving?  One reason is that there is this weird paradox when it comes to saving.  It is that when it is most important for you to be saving, you earn the least and therefore the most difficult for you to give up a portion of your income to savings.

Then there becomes the issue of people thinking that the small portion of their income that they can do without isn’t significant and therefore and so they figure why bother.  But that thinking is wrong!

Even if a person contributes $10 a paycheck to something earning 6% return a year starting when they are 20, it will amount to over $55,000.  That is not insignificant.

So what are some tips that people can use to help with their savings?  First, I would recommend, no surprise, start as young as possible.  Contribute whatever you can – no amount is insignificant.

Secondly, once you get to a point where you have financial stability start deducting a regular amount from your paycheck and contributed that.  At least 10% of your pay should be going to this but the more you can contribute, the more you will make your money work for you!

Lastly, if your company offers any sort of defined contribution retirement plan, take advantage of this to the fullest.  You are guaranteeing yourself a 100% return (if they match your investment.  If they only pay a percentage then you get percent return guaranteed).  In the first example above, that $500 investment amounts to almost $150,000 if there is a 100% defined benefit!

The power of compounding interest is THE best pay to make your money work for you.  Use it!