Article published by José Alberto León Alonso in Diario de Avisos on 05/18/14.
I have already mentioned on several occasions that, for a small investor, the best way to save is to invest in stocks linked to a stock index (what in the jargon is known as “index funds” or “passively managed”). This investment method is deduced from the Efficient Market Hypothesis (EMH), established by Eugene Fama, which earned him the Nobel Prize last year.
According to Fama, stock prices collect all available information, and all new information is reflected in prices immediately, so that they follow an erratic and unpredictable evolution. The corollary of this theory is that the best way to invest in the stock market is to do so in index funds, which replicate a stock index and diversify risk, and not in supposed professional managers, because you cannot beat the market since there are no reliable forecasts. This hypothesis is confirmed (among others) by the work that Nitzsche, Cuthbertson and O'Sullivan carried out in 2006 compiling the existing literature on the profitability of investment funds in the United States and England. From their analysis they concluded that less than 5% of equity investment funds had a higher return than stock market indices, and that active management did not seem to improve the profitability of the funds. So the corollary of Fama's theory, “invest in index funds,” seems like a good recommendation for the small investor, since few money managers manage to beat the market and charge handsome fees for it. It is true that, although there are few who beat the market consistently, it is evident that there are people with a special ability to do so. What happens is that these people are dedicated to large assets, and not to small savers. Warren Buffett, one of those few people with investment skills, which has made him a billionaire, once said that "when the ignorant investor recognizes his limitations, and acts accordingly by indexing his investments, he is no longer ignorant." So for the small investor, there is no doubt. Diversify risk by replicating stock indices (IBEX35, Eurostock, DAX, S&P, etc.). Now, the market offers two instruments to invest in this way: index investment funds and ETFs (Exchange-Traded Funds). What is the best option?
Index funds replicate an index, purchasing its securities with the given weights, and thus emulating its performance. ETFs, or exchange-traded funds, reproduce a certain stock index but, unlike indexed investment funds, they are listed on the stock exchange, just like a stock, and their operations are the same as that of stocks, since they are listed throughout the stock market session and have the same taxation.
Advantages of ETFs:
1. The most important: ETFs usually have lower management fees than funds (including index funds), which translates into a greater benefit for the investor. Even minimal differences are important, because in the long term the accumulation of these minimal differences become significant. The average annual expense for a variable income indexed investment fund is around 1.2%, while ETFs charge around 0.3%. Of course, in both cases there are those who charge more or less.
2. Real-time operations: the ETF investor is able to sell at the price he wants, since he does not have to wait for a closing price as happens with Funds, and in this way he can condition his sale (or purchase) on a minimum (or maximum) price. Mutual funds set their price only once a day, and that means you don't really know at what price you're buying or selling. If the index does not change much during the session, this difference will not be significant, but on a day of euphoria or a stock market debacle, it can be important.
3. Funds need to keep some liquidity to deal with participant outflows, while ETFs do not, so in a rising market their profitability will be somewhat higher. On the contrary, in a bear market its profitability will be somewhat worse.
Advantages of index funds:
1. To buy and sell an ETF you need to pay commissions to the broker (which a normal stock would pay), while buying and selling funds is usually free. This makes investing small capital in ETFs less attractive.
2. Fund dividends are automatically reinvested at no cost, an alternative that ETFs do not offer. In ETFs, it is the investor who must reinvest the dividends received, incurring the corresponding acquisition costs.
3. Funds are exempt from tax when they reinvest their assets in another fund, which is not the case with ETFs. Thus, if, for example, one wanted to transfer the assets invested in the American stock market to the Spanish stock market, if the investment had been made in Funds, its value would be “transferred” from one fund to another without paying anything, while if it had been made in an ETF, one would have to sell the ETF from the American stock market and buy the one from the Spanish stock market, paying the corresponding taxes on the profits obtained.
In summary, an ETF will be more interesting than a conventional fund if the investor is going to make a single investment in a certain entity, and not small periodic contributions, and plans to hold the ETF long enough for the annual benefit of the lower management fee to compensate for the broker's higher buying and selling fees, as well as the loss from the non-reinvestment of the dividend.
Therefore, for those who want to make small investments, or like to buy and/or sell frequently (for example, investing their savings every month), index investment funds are your best option. On the contrary, for those who plan to make a single investment in a certain entity and maintain it for years, the lower commissions of an ETF will be more convenient. Of course, in any case, of all the funds or ETFs available for the same stock index, choose the one with the lowest commissions.
