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ETFs and index funds: What investors should know

Indexed investments have grown in popularity. While attention in the last few years had mainly concentrated on exchange-traded funds (ETFs), the focus has recently shifted to include index funds as well. Both product classes are transparent, cost-efficient investment options, yet they differ from one another and have their own specific advantages.

March 16, 2020

Investors in ETFs and index funds not only save on fees, but also save time. Passive investments of this kind do not require stock picking or constant monitoring of the markets. This is because index funds and ETFs track a benchmark index as precisely as possible, very closely mirroring its performance. Since they track an entire market, passive funds are diversified, thus minimizing risk.

Active funds, in contrast, always try to beat the market, i.e. they strive to achieve a better return than their benchmark index. However, numerous studies have shown that few actively managed funds actually succeed in outperforming their respective indices over the long term.1 Consequently, passive investments now account for one-third of all mutual fund assets invested worldwide (see pie chart). Around 70% of passively managed assets are invested in unlisted index funds and only around 30% in ETFs.

Source: Morningstar, Credit Suisse, data at the end of December 2019

Index funds or ETFs?

The answer to the question of which are better depends on the chosen investment strategy and the planned holding period. It is often advisable to have a combination of ETFs and index funds in one’s portfolio.

One of the criteria for deciding between index funds and ETFs is tradability. If intraday tradability is a crucial requirement, then only ETFs are worth considering. Since ETFs are listed on securities exchanges, market makers guarantee trading liquidity. Calculation agents continually calculate the indicative net asset value (iNAV) on which market makers base their binding bid and ask prices.

Shares of index funds, in contrast, can only be directly bought from or sold to the fund provider at their net asset value (NAV) once a day. Whenever investors buy or sell shares of index funds, they incur transaction costs in the form of issue spreads or redemption spreads. This mechanism is also referred to as dilution protection for existing investors.

The table below provides guidance on choosing the right product:

Tabular overview - differences and similarities between index funds and ETFs

The circumstances determine the choice

Unlike the big difference in tradability, there is hardly any difference between ETFs and index funds in terms of their total expense ratio (TER). The fund’s country of domicile and the resulting tax consequences are important aspects to consider when making a choice. Depending on the circumstances and the type of investor, ETFs and index funds can both have their advantages.

Apart from being subject to different withholding tax rates, another major differentiating factor for ETFs and index funds in Switzerland is the stamp duty. Like stocks, ETFs, too, are subject to a stamp duty on both buying and selling transactions. However, whereas the stamp duty paid when buying or selling ETFs domiciled in Switzerland currently amounts to 0.075%, it is 0.15% for foreign ETFs.

Unlisted Swiss funds, in contrast, are not subject to any stamp duty on purchases or redemptions. When buying shares in a foreign-domiciled index fund, investors have to pay a stamp duty currently amounting to 0.15%; only redemptions are exempt from the stamp tax.

Index funds are more suitable for short-term investments

When looking at the expenses over a given period, it becomes clear that private investors who wish to hold an ETF only for a short period can expect to pay high costs. This is because a stamp duty is incurred on each transaction. Index funds therefore are usually a better solution than ETFs for private investors in Switzerland who have a relatively short-term investment horizon. From a long-term perspective, though, it is wise to pay particular attention to administrative costs (ongoing costs) and tax efficiency related to withholding taxes.

Investors who are thinking about investing in an index through either ETFs or index funds should first analyze the benefits of the two types of funds. Whether ETFs or index funds are the better option depends on the market, the fund’s country of domicile and the investor’s tradability needs.

Investments in financial instruments can entail market risks as well as the risk of loss of capital, as they are subject to developments on the financial markets, which are not precisely foreseeable. The exact risk profile of Credit Suisse Index Fund Solutions is determined by the selection of the specific sub-fund and depends on the replicated indices. Unlike active investments, passive investments are strictly linked to the respective market, which is why a passive investment can be expected to incur a loss that is proportionate to any market loss. This also means that a significant outperformance can not be expected.

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Sources

1 According to the Standard & Poor’s Index vs. Active (SPIVA) Scorecard, only 21.5% of active US equity funds outperformed the S&P 500 Index over a five-year period (see https://us.spindices.com/spiva). 

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