Low-cost investing with index funds and ETFs

Low costs for index funds and ETFs as a key advantage

People invest for various reasons. And because the reason impacts the investment strategy, it’s worthwhile to take an explanatory look at actively and passively managed investments.

Actively managed funds aim to beat the benchmark, thereby generating excess returns – or alpha – for investors. Therefore, portfolio managers must perform transactions regularly and rely on their analysts to supply them with the required information. This means that active funds result in higher costs. Personnel expenses and fees for securities trading are generally passed on to the investors.

Those looking to invest in a particular theme, country, sector, or industry on the market and only in the best possible securities and potential future winners should opt for active funds.

Otherwise, exchange-traded funds (ETFs) and index funds offer investors the opportunity to make low-cost investments. Unlike traditional funds, they are managed passively and not actively, which saves costs.

Passive investments use an index as the underlying asset. This may be an index for equities, raw materials, or interest rate products. They replicate them 1:1, either physically or synthetically. Low research costs and a high degree of automation mean that management costs are low. In other words, investors can participate in the market at very affordable rates but may not generate excess returns. Depending on investor needs, ETFs and index funds are an interesting alternative to classic investment funds.

ETFs or index funds?

An ETF replicates an underlying index 

The most common instrument for private investors is the exchange-traded fund. These are traded on the stock market, which means transparency and liquidity. But what exactly is an ETF? It replicates the performance of an index, such as the SMI, either physically or synthetically.

Physical (or "direct") replication relates only to securities that are in the reference index itself – always in accordance with the respective weighting.

But the reference index can also be replicated synthetically. Under this indirect method, the fund's portfolio also contains assets that do not correspond to the reference index. Replication is based on a swap with a bank.

Although the same protective regulations apply to both forms, direct ETFs are more popular with investors because there is no issuer risk for the bank that holds the swaps.

Index funds are traded once per day 

Non-exchange-traded funds offered by financial institutions work in nearly the same way. They are often somewhat cheaper than ETFs because a listing on the stock exchange costs money. Private investors have only been permitted to invest in the index funds of Credit Suisse since 2017; previously, they were exclusively for institutional investors.

These index funds always replicate the index physically, meaning they buy equities or bonds based on their index weighting. Unlike ETFs, index funds are traded only once per day on the stock exchange at net asset value.

Index-based investing is restrictive

Investors must be aware that index-based investing will restrict their options. It is not possible to favor or exclude specific companies. For instance, no corrections can be made if a security or sector is overvalued. Indices, which are mostly cap-weighted, exacerbate this situation. Furthermore, stock indices often cover only part of the market because the leading indices of a country (such as the SMI or DAX) include only blue-chip stocks.

Index funds and ETFs are not immune to risks either. If the market drops, so do the indices. Actively managed funds could try and reverse this trend, but passive funds cannot. And as these funds track the index, they are also unable to generate a higher yield than the market.

Cost-effective investing: Tracker certificates as a third alternative

The third investment option with passive index solutions are tracker certificates. They also replicate the underlying index 1:1, but indirectly. In terms of costs, they are often the cheapest alternative, because there are generally no management fees. The purchase of products is sometimes also cheaper than with passive funds.

However, they differ when it comes to returns. Unlike exchange-traded funds and index funds, stock dividends are not always passed on to the investors. This can mean lower income. The risk is also somewhat higher for certificates because if the product issuer goes under, investors can suffer a total loss.

So which of the three options is the right portfolio investment strategy? Where do the positives outweigh the negatives? Investors must decide for themselves. Index funds, ETF funds, and tracker certificates are all interesting alternatives for those investors who opt for passive investing.