Passive investment tools: how to invest in practice

A Keren Neemanut (קרן נאמנות), or mutual fundAn investment vehicle that allows many investors to pool their money into a shared portfolio of assets managed by a professional., pools money from many investors and invests 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 every share separately, you buy units in the fund and immediately gain exposure to a broad range of assets.

A mutual fund may be active, with a manager who selects shares, or passive, with a manager who tracks an index.

Advantage:

• Simplicity—the purchase can be made easily through a bank account.

Disadvantage:

• Mutual funds do not trade 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 their management fees can sometimes be high or very high.

These three instruments serve one purpose: tracking an index such as the 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 the legal structure.

Keren Sal (קרן סל)—ETF, or exchange-traded fund

This product trades on the stock exchange throughout the trading day, like a share. You can therefore buy and sell it at any time at a changing market price, providing high flexibility and liquidityThe speed and ease with which money can be withdrawn from an investment and converted into cash in a bank account without significant penalties..

Keren Mehaka (קרן מחקה)—index-tracking mutual fund

This is a passive mutual fund that tracks an index but does not trade during the day. Purchases and sales take place only at a price set at the end of the trading day. Its index exposure can be very similar to that of an ETFA 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 way you use it is slightly different.

Teudat Sal (תעודת סל)—ETN, or exchange-traded note

This product is based on a financial institution's obligation to deliver the index 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, ETNs have almost disappeared and have been replaced by ETFs. They still exist in the United States and Europe, but are less common and are mainly used for more specialized or complex products.

All these instruments aim to track an index, but in practice there may be some difference between the product's performance and the index's performance.

When companies in an index distribute profits as dividends, the fund needs to decide what to do with them:

• A Keren Mechaleket (קרן מחלקת), or distributing fundA fund that transfers dividend or interest income directly to investors’ bank accounts., transfers the cash directly to your account. It suits someone who needs regular cash flow, but every distribution creates a taxable eventAn action in an investment portfolio (such as selling at a profit) that triggers an immediate tax payment to the state..
• A Keren Tzoveret (קרן צוברת), or accumulating fundA fund that reinvests dividends back into the fund’s assets in order to increase the value of each unit., reinvests the dividends inside the fund. The money received is added to the investment and starts working, strengthening the effect of 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. over time. It also offers tax deferralThe ability to pay capital gains tax only when money is withdrawn from the plan, rather than when the gain is generated.: as long as you do not sell the fund, you do not pay tax. All the money therefore keeps working and generating returns instead of part of it leaving the investment as tax along the way.

Long-term investors will generally prefer an accumulating fund because of both the compound-interestThe "price of money" – the amount paid for the use of someone else’s money, as income to the depositor or as a cost to the borrower. effect and tax deferral. Investors seeking regular income, by contrast, will prefer a distributing fund.

When investing in international indices, you can use funds domiciled in different countries, and this difference matters more than it may seem.

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

How do you choose?

There is no single right answer. 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 risk, taxation, and investment accuracy.

Physical fund

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

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

Irish funds from BlackRock, under the iShares brand, generally use physical replication and actually buy the index's shares.

Advantages:

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

Disadvantages:

• The fund must continually adjust to changes in the index as companies enter or leave and weights change
• Tracking errors may occur, creating a small deviation from the index
• Dividends are taxed

Synthetic fund

A synthetic fund does not buy the shares. Instead, it enters into a contract with a bank that promises to provide the index return. Its advantage is very accurate tracking and sometimes tax benefits, but it adds counterparty risk through dependence on the bank's stability.

For example, funds from Invesco use synthetic replication and receive the index return through contracts with financial institutions.

Advantages:

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

Disadvantages:

• Counterparty risk—dependence on the financial institution providing the contract
• Greater complexity

To reduce the risk, funds generally spread the contracts among several financial institutions and settle them regularly.

When investing in foreign indices, 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 an American index such as the S&P 500, the underlying investment is made in dollars even if you bought the fund in shekels. A change in the dollar–shekel exchange rate can therefore affect your return.

Advantages of a hedged fund:

• Greater stability of returns in shekels
• Less dependence on currency fluctuations
• Reduced or neutralized currency risk
• Suits someone who wants to avoid exchange-rate effects

Disadvantages of a hedged fund:

• Management fees are generally higher because of hedging costs
• You give up a possible gain if the dollar strengthens

Advantages of an unhedged fund:

• Management fees are generally lower because there is no hedging cost
• You may also benefit if the currency strengthens
• Suits investors willing to accept additional risk and who believe the foreign currency will strengthen

Disadvantages of an unhedged fund:

• Higher currency risk
• Exchange-rate fluctuations can have a significant effect on returns
• A weaker foreign currency may reduce the return in shekels

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

Two possible scenarios

Assume you invested in a fund tracking the S&P 500 and the index rose by 10%.

What happens to the return in shekels?

• When the dollar strengthens: Each dollar is worth more shekels. You benefit from both the rise in the index and the stronger dollar, so your return in shekels can be higher than the index return.
• When the dollar weakens: Each dollar is worth fewer shekels. Part of the gain from the rising index is eroded by the currency movement, so your return in shekels can be lower than the index return.

In an unhedged fund, the dollar can increase your return in shekels, but it can also reduce it.

What might suit you?