Updated Apr, 2020

ETFs vs managed funds vs index funds

It is easy to get confused since there are two separate dimensions when talking about ETFs vs managed funds vs index funds –

  • The Stock selection style (index-tracking vs actively managed); and
  • The Structure/investment vehicle that can hold a basket of underlying shares and offer them to be purchased as a single unit (managed fund vs ETF vs LIC).

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Stock selection style — index-tracking vs actively managed

An index tracks a market.

For example,
The S&P ASX200 index tracks the 200 largest Australian publicly traded companies.
The MSCI World index tracks the largest 85% of publicly traded companies in 23 developed countries.
The MSCI Emerging Markets index tracks publicly traded companies in 23 emerging countries.

They track them by ‘market capitalisation’ (what the market collectively has priced each company at), which means if one company is valued at double another company, then that company will be weighted at double the proportion.

For example, if you purchase a share in an ASX200 index-tracking fund, you own a piece of all of Australia’s largest 200 companies in their valuation proportions. So if CBA is currently valued at double BHP, there will be twice as much CBA as BHP within your index fund in dollar value.

There is more than one investment vehicle that can be used to invest in index funds, which we will go through in a moment, but the important thing to understand is that an index fund (a fund that tracks an index) has no risk of a fund management company selecting a subset of stocks that will underperform the market. You’re guaranteed the returns of the market.

The alternative is actively managed funds. You might think fund managers can pick better-performing stocks and get a return making up for their higher fee and more, but the data is out. S&P has been tracking active management performance for a long time and release regular SPIVA reports. Their findings are that while over any 1 or 2 year period, an active manager may outperform the index, over 15+ years, more than 80% of active managers fail even to match the index after fees. You also expose yourself to key person risk (reliance on key personnel who may make a mistake), and agency risk (the risk that management uses its authority to benefit itself at shareholders’ expense).

The 3 structures

A fund’s investment vehicle/legal structure doesn’t tell you anything about what assets the fund invests in.
The shares held can be stocks, bonds, real estate, infrastructure, commodities, cash, or any combination.

1. Managed funds

The company holds the underlying shares, and you purchase directly through that company.
When you buy or sell a share in the fund, the fund goes and buys or sells the underlying shares of each company in the fund. This ensures that the underlying shares’ value will match what they’re worth if you bought them individually.

Both actively managed funds and index-tracking managed funds are available.

An index tracking fund will often have the word index in the fund name, and if not, it will mention it early in the product’s main web page (usually the title or at least the first paragraph) or else in the PDS.

2. ETFs – Exchange Traded Funds

ETFs are simply listed versions of managed funds. Instead of purchasing directly through the fund management company, you buy a share of the fund on the stock exchange. As per the name, it is a fund that is ‘exchange-traded’. Again, there are both index-tracking ETFs and actively managed ETFs.

3. LICs – Listed Investment Companies

The above two types of investment vehicles are called open-ended funds, in that, as an investor buys or sells shares of the managed fund or ETF, the fund will go and buy or sell more of the underlying shares, so the price tracks the actual value of the underlying shares it holds.

LICs are closed-ended funds which means that the company purchases or sells the underlying holdings at their discretion. When investors buy shares, no additional shares are created. If there is a high demand for an LIC’s share, the price goes up above the value of the underlying basket of shares within it (called trading at a premium to NAV – Net Asset Value). Conversely, if there is low demand, the LIC’s share price falls below the value of the underlying basket of shares (called trading at a discount to NAV).

Buying at a premium is generally not a good idea – why would you pay more than the value of the underlying assets?

LIC advocates say that you can get a free lunch buying LICs at a discount to NAV, but this is a fallacy. The price of an LIC is at a discount because the market sees a risk (often manager risk) and is pricing-in the risk by valuing it lower than its net asset value, so when it is at a discount, there is no free lunch, you’re paying for the discount with a higher risk.

Provided you purchased at a time of discount, you’re at least getting a higher expected return to compensate for the higher risk you’re taking, but you may buy it at a time when it is not at a discount but later on have it face management uncertainty, and then you face the risk without the associated reward. Why take on this added risk at all when you can just buy an index fund and remove this risk entirely.

Summary

A fund has two dimensions – the structure and the stock selection style.

Some funds are index tracking. Some are actively managed. Some hold stocks. Some hold bonds. Some hold gold. Some hold property. The fact that a fund is an ETF or a managed fund, or an LIC doesn’t tell you anything about the investments it holds.

The most important decision is the stock selection style – whether to choose an index fund or an actively managed fund.


ETFs vs managed funds

For their index-tracking funds, the Vanguard Personal Investor platform offers you the choice of using a managed fund or an ETF.

Advantages of managed funds

The managed funds allow you to BPay directly in, which means there is no brokerage cost to buy and sell, so you can BPay in as frequently as you like. In contrast, for the ETF, there’s a minimum brokerage cost each time you buy or sell, so with ETFs, you want to save up and buy in larger chunks less often to minimise purchasing costs (more on this below). So, if you’re going to invest more frequently, managed funds have an upside. The upside is that your money is working for you sooner, whereas, with an ETF, your money is sitting out of the market while you accumulate enough funds to make your next purchase.

Managed funds have another upside that is rarely mentioned. Since ETF prices move with the market, when news comes out, some people go and check the portfolio. News alert comes out? Check the portfolio. Trump tweets something? Check the portfolio. Sitting on the toilet? Check the portfolio. For many people, it’s not good for their mental health and their ability to remain invested.

Managed fund prices only update once per day (after market close). Transactions only process once per day (after market close). There’s no longer a point or a personal drive to check the portfolio during the day. Some find that the once per day updates allows you to detach your emotional connection from your portfolio.

The managed funds also allow you to set up automated BPay directly in on pay day, which means you don’t need to look at your investments at all. Behavioural risk is one of the major risks and is discussed more in the following article on mitigating risks.

Advantages of ETFs

One advantage of ETFs over the managed funds is that when you purchase a share of an ETF, you pay whatever the price is at that time. In contrast, with managed funds, you put in a purchase order, and the shares are bought after the market closes that day, so you may end up paying more or less per share than you intended. For a long-term investor, this won’t matter because it will even out over time as you buy regularly.

Another advantage of ETFs is when you have plans to buy or sell very large parcels, the cost to buy and sell will be cheaper buying an ETF and using a flat-fee broker compared to the managed fund’s buy/sell spread.

A further advantage of ETFs is that they’re more tax-efficient than their managed fund counterpart.

In managed funds, the entire fund is one pool of assets, so other investors selling their units triggers capital gains for all investors of the fund. So even if you don’t sell any units, you still have to realise gains. This doesn’t occur with ETFs due to their tax structure, and instead, you defer these capital gains until you sell your ETF shares.

An example of this was during the coronavirus market downturn where VGAD paid no mid-year distribution (due to currency hedging), yet the managed fund version was forced to pay out a distribution due to realised capital gains. This is despite the two funds having the same base fund because they’re two different pools of money and must be managed according to the fund structure.

Generally, you want to delay your gains until as late as possible because that additional money could be compounded for potentially another 30 years or more otherwise.

Important note – I’d like to stress that there are two distinct tax advantages to be aware of:

  1. The first and most important is the low-turnover tax nature of index funds vs actively managed funds. This advantage of index funds is shared between both ETFs and managed funds. The improved tax outcome is because as companies within an index fund grow or shrink in value, so does the value of their shares within your fund, so the only selling in regards to adjusting holdings in an index fund is when a company drops out of the index.
  2. The second tax advantage is only for ETFs, which is that when other investors sell shares in the same fund, an ETF (and not a managed fund) can delay those gains until they sell their own ETF shares, whereas for managed funds, you realised gain each time any investor sells shares in the fund.

A more in-depth explanation of the mechanics of how ETFs are able to be more tax-efficient can be found in the first section of this article: How is VDHG tax-inefficient?

Summary of ETFs vs managed funds
ETFs
  • tax efficient
  • priced continuously throughout the day
  • no autoinvest [1]
  • need to save up and buy larger trade sizes [2]
  • cheaper for large trade sizes
Managed funds
  • tax inefficient
  • priced only at the end of the day
  • autoinvest
  • can cost-effectively buy/sell small amounts
  • cheaper for smaller trade sizes

* The above compares ETFs and managed funds specifically through the Vanguard Personal Investor platform.
[1] You can get autoinvest with ETFs through Pearler.
[2] You can get free brokerage on ETF purchases through Superhero allowing frequent small purchases without sacrificing the tax efficiency of ETFs. It is not CHESS sponsored just as Vanguard Personal Investor is not CHESS sponsored. If you want a low-cost CHESS sponsored broker, you can use Stake’s $3 ASX trades allowing relatively small trade sizes cost-effectively.
Edit: CMC Markets now offers free brokerage on purchases below $1,000 (limited to one purchase per security per day), and it is CHESS sponsored.


How often to buy a parcel of shares

How often to buy a parcel of shares will depend on whether you purchase the ETF version or the managed fund version.

With the managed fund version, you can buy as often as you like without any added cost, but to buy ETFs, you need to buy through a broker, and there is a minimum brokerage cost per purchase.

Investing small parcels means higher brokerage costs, leading to a drag on returns as you lose more of it before it even gets into your investment.

For example, let’s say you decided on investing $1,500 per month split evenly between 3 index funds. If brokerage had a minimum cost of $10, then to make 3 purchases (one of each) every month would cost you $30 or 2% before your money even got into the investment, whereas waiting for 2 months and then alternating between the 3 funds would cost you $10 per $3,000 or 0.33% — one sixth of the cost.

However, waiting too long before investing also means you miss out on market gains.

A good rule of thumb is saving and investing parcels of around 3-5k if you can accumulate that within 3 months, but this calculator is a bit more precise.


Are ETFs accurately priced?

Managed funds do all their buying and selling after market close, so the price you buy and sell at is exactly their net asset value (NAV).

For the most part, ETF’s are accurately priced because there are market participants called ‘market makers’ that the ETF provider appoints who can convert between a basket of the underlying assets and units of the ETF, and this keeps the price in check. Here’s a good explanation of how this works.

How ETFs Work – Bloomberg

However, there are certain times where it’s more likely to drift from NAV, and I go into this in the following section and how to avoid the problems associated with it.


With ETFs – avoid trading the first and last 15 minutes of the day, and always use limit orders

With managed funds, all the buying and selling of orders are done at the end of the trading day, and they use the actual net asset value of the underlying shares.

However, with ETFs, the price needs to update constantly throughout the day, and the difference between the net asset value (NAV) and the ETF share price can be more volatile during the start and end of the day when price discovery is being established by the market.

You should

  • Never trade in the first or last 15 minutes of the trading day;
  • Never place an order during off-market hours expecting it to be filled at the market open;
  • Always use limit orders. It’s just a matter of eliminating tail risk (those couple of times market makers have suddenly disappeared and spreads have blown out).

When you make a purchase, ignore the last price because, for lower liquidity ETFs, the last price could have been hours of trading earlier or even the day before and no longer reflect the price that people are willing to buy and sell at.

Just place your order a few cents below the bid if selling or a few cents above the ask if buying. It will act just like a market order, but you’ll never have any big surprises.

Being tricky and trying to price it lower when buying and higher when selling doesn’t actually help.

Vanguard suggests this for ETFs and calls it placing marketable limit orders.