Passive Investment Vehicles: How They Work in Practice

Mutual fundAn investment vehicle that allows many investors to pool their money into a shared portfolio of assets managed by a professional. (Mutual Funds) are products that pool money from many investors and invest it in a basket of securitiesA general term for a tradable financial asset (such as a share, bond, or unit in a fund) that represents a right to an asset or to profits. according to a defined policy. Instead of buying each stock separately, you buy "participation units" in the fund and gain immediate exposure to a broad range of assets.

It is important to know that a Mutual fund can be active (a manager selects stocks) or passive (a manager tracks an index).

Advantage:

• Simplicity – purchases can be made easily through your bank account.

Disadvantage:

• They are not traded in real time—you can buy or sell them only once a day, at the price set at the end of the trading day, and management fees are sometimes high to very high.

These three instruments are designed for one purpose: to track an index (such as S&P 500An index composed of 500 of the largest and leading companies traded on U.S. stock exchanges., TA 35The flagship index of the Tel Aviv Stock Exchange, consisting of the 35 companies with the highest market capitalization traded in Israel., or Nasdaq 100An index comprising the 100 largest non-financial companies listed on Nasdaq, with a strong emphasis on technology.). The difference lies in the "user experience" and legal structure:

Exchange-Traded Fund (ETF – Exchange-Traded Fund)

A product traded on an exchange during the trading day, similar to a stock. In other words, it can be bought and sold at any time at a changing market price. This provides flexibility and high LiquidityThe speed and ease with which money can be withdrawn from an investment and converted into cash in a bank account without significant penalties..

Index-tracking fund

A passive Mutual fund that tracks an index but is not traded during the day. Purchases and sales are made only at the price set at the end of the trading day. In terms of index exposure, it can be very similar to an Exchange-Traded Fund (ETF)A security traded on an exchange that tracks a particular index, allowing an investor to buy a "basket" of assets in a single transaction., but the user experience is somewhat different.

Exchange-traded note (ETN – Exchange-Traded Note)

A product based on the commitment of a financial institution to provide the index's ReturnThe profit (or loss) from an investment over a certain period, usually expressed as a percentage of the original amount invested., rather than on direct ownership of the assets. In Israel, Exchange-traded notesAn older index-linked product that represented a contractual obligation by the issuer to pay the investor the return of the index. have almost disappeared and been replaced by Exchange-Traded Funds. They still exist in the U.S. and Europe but are less common and are used mainly for unique or more complex products.

It is important to know that all these instruments aim to track the index, but in practice there may be some deviation between the product's performance and the index's performance.

When the companies in an index distribute profits (dividends), the fund must decide what to do with them:

• Distributing fundA fund that transfers dividend or interest income directly to investors’ bank accounts. transfers cash directly to your account. It is suitable for those who need ongoing cash flow, but creates a Taxable eventAn action in an investment portfolio (such as selling at a profit) that triggers an immediate tax payment to the state. (tax payment) with every distribution.
• Accumulating fundA fund that reinvests dividends back into the fund’s assets in order to increase the value of each unit. reinvests dividends within the fund. This means that the money received is added to the investment and begins working, reinforcing the Compound interestA situation in which the returns accumulated on an investment are reinvested and generate additional returns themselves, creating accelerated growth of the money over time. effect over time. In addition, there is a Tax deferral advantageThe economic benefit created when money that would otherwise have been paid as tax remains invested and continues to earn returns over the years.—so long as the fund is not sold, no tax is paid. This way, all the money continues working and generating Return, rather than part of it "going out" to taxes along the way.

Generally, long-term investors will prefer an Accumulating fund, both because of the Compound interest effect and Tax deferralThe ability to pay capital gains tax only when money is withdrawn from the plan, rather than when the gain is generated.. In contrast, investors seeking ongoing income will prefer a Distributing fund.

When investing in international indices, you can do so through funds domiciled in different countries, and this difference is more important than it may seem.

The differences are reflected in management fees, dividend taxation, estate tax, trading costs, and ease of use.

So how do you choose?

There is no single correct answer, and the choice depends on the investor's profile:

When a fund tracks an index, it is important to understand how it does so, because the tracking method affects the investment's risk, taxation, and accuracy.

Physical fund

A physical fund actually buys the stocks or bondsA type of "loan" that an investor provides to a government or company in exchange for repayment of the principal plus interest. in the index according to their weightings.

For example, a fund tracking the S&P 500 will hold shares of Apple, Microsoft, Amazon, and the other companies in the index.

BlackRock (iShares) Irish funds, for example, generally use a physical method and actually buy the index's stocks.

Advantages:

• Direct investment in assets—the money is genuinely invested in the companies themselves
• Less dependence on an external party
• A simple and intuitive structure

Disadvantages:

• The fund must continuously adjust to changes in the index as companies enter and leave, and weightings change
• There may be “tracking errors”—small deviations from the index
• Dividends are taxed

Synthetic fund

A synthetic fund does not buy the stocks; instead, it enters into a contract with a bank that guarantees the index Return. Its advantage is highly accurate tracking and, sometimes, tax advantages, but it adds “issuer risk” (dependence on the bank's stability).

For example, Invesco funds use a synthetic method and receive the index Return through contracts with financial institutions.

Advantages:

• Highly accurate index tracking
• Sometimes a tax advantage, such as avoiding dividend taxation in certain cases
• May improve Return over time

Disadvantages:

• Issuer risk—dependence on the financial institution that provides the contract
• More complex to understand

To reduce this risk, funds generally diversify contracts among several financial institutions and settle accounts regularly.

When investing in foreign indices, it is important to understand that your Return can be affected by two factors:

• The performance of the market itself.
• Changes in the exchange rate.

For example, if you invest in a US index such as the S&P 500, the investment is actually made in dollars—even if you bought the fund in shekels. Therefore, changes in the dollar-to-shekel exchange rate can affect your Return.

Advantages of a hedged fund:

• Greater stability in shekel returns.
• Less dependence on currency fluctuations.
• Currency risk is reduced or eliminated.
• Suitable for those who want to avoid exchange-rate effects.

Disadvantages of a hedged fund:

• Management fees are usually higher due to hedging costs.
• You forgo potential gains if the dollar strengthens.

Advantages of an unhedged fund:

• Management fees are usually lower, as there are no hedging costs.
• You can also benefit from currency appreciation.
• Suitable for investors willing to take additional risk who believe the foreign currency will strengthen.

Disadvantages of an unhedged fund:

• Currency risk is higher.
• Currency exchange-rate fluctuations can significantly affect returns.
• Currency depreciation may hurt returns in shekels.

Example: How does a change in the dollar exchange rate affect returns?

Two possible scenarios

Suppose you invested in a fund that tracks the S&P 500, and the index rose by 10%.

What happens to returns in shekels?

• When the dollar strengthens, each dollar is worth more shekels. In this case, you benefit from both the index's rise and the strengthening dollar, so the return in shekels may be higher than the index's return.
• When the dollar weakens, each dollar is worth fewer shekels. In this case, part of the gain from the index's rise is eroded by the currency change, so the return in shekels may be lower than the index's return.

In an unhedged fund, the dollar can increase returns in shekels—but it can also reduce them.

So what might suit you?