As a followup to yesterday’s post about mutual funds, I thought I’d talk today about the merits of exchange traded funds (ETFs) vs. low cost index funds. Which is a better choice and why?
What are index mutual funds?
Index mutual funds are simply mutual funds that track a market index such as the S&P 500, Wilshire 5000, or Barclays US Aggregate Bond Index. Fund management is totally automated, so the expense ratios are much lower than for most actively managed funds. In fact, in most cases the expense ratios are less than 0.50%.
Like other mutual funds, index funds are typically bought and sold at the end of the day, which means that you don’t have a lot of control over the price at which you buy or sell. The good news is that, with few exceptions, you can buy them direct from the mutual fund company, so there are no brokerage fees.
What are exchange traded funds?
Like index funds, most ETFs are designed to track a market index of some sort. The main difference is that ETFs are bought and sold just like individuals stocks. This means that they’re traded throughout out the day, but you have to pay brokerage fees whenever you buy or sell. The good news here is that the expense ratios of ETFs are typically lower than for their index fund counterparts.
Are index funds or ETFs a better choice?
Before you make a decision, ask yourself a few questions:
- What are the exact costs for the ETFs and index funds that you’re considering? Fees can vary widely, so don’t just assume on type of investment is more/less expensive than other. Instead, make a direct comparison.
- How large is your investment portfolio? Some index funds require a minimum initial investment. If you can’t afford the minimum, you might want to consider purchasing an ETF. Then again, if you’re not buying large amounts, the broker fees associated with ETFs can kill you.
- How frequently are you going to be purchasing? Since brokers charge for buying and selling ETFs, you have to factor in the added costs. If you regularly invest small amount, you may do better with index funds. The cost of rebalancing is also an important consideration.
And above all, don’t get sucked in by the hype surrounding the latest and greatest investment products. For example, the newest trend amongst money managers appears to be offering ETFs with hedge fund-like like performances. Keep your eye on the ball and think long-term.
What about you?
Given the choice, would you pick index funds or ETFs for your investments?
If you are going through Vanguard Brokerage services you can buy and sell Vanguard ETFs for free.
Thank you for explaining the advantages and disadvantages of ETFs. I am interested in investing in ETFs but am unsure of exactly how to go about it. Any help would be greatly appreciated, you can contact me directly at [email protected]
I generally use index mutual funds than ETFs mainly because I dollar-cost-average. I don’t want to pay the ETF fee everytime I buy into a certain index.
But I do use ETFs if I plan on doing any ultrashorts or longs on a particular index because Vanguard doesn’t let you time it when you buy/sell mutual funds.
I admit I’m a bit bias, because I’m an option trader, but I prefer the ETF. If I’m already going to get a decent return with low cost I might as well squeeze some extra income from the ETF by selling covered calls and the sorts.
I prefer to hold them in my ROTH because of the tax advantages. Paying taxes on trading income is a pain in the butt.
I think that David (commenter before) may be technically right about ETFs trading above/below the actual value of the stocks in the ETF, I think in practice that doesn’t happen with popular ETFs. Those that do arbitrage for a living are certainly quick to swoop in to make sure the value of an ETF is in line with the underlying holdings.
Also, with an account at Sharebuilder, you can reinvest dividends into fractional shares by setting the right account setting.
Some more important points about ETFs/Funds –
While ETFs match a basket of stocks like an index fund, because of their traded nature they can be at a premium or discount to the actual values of the stocks.
Mutual Funds are valued at their Net Asset Value at the end of the trading day and that’s their price.
What this means is, with an ETF you could pay more than the index is worth, or less depending on market forces. Mutual Funds are always valued at their actual value.
In addition, ETFs are subject to the Bid/Ask spread which introduces more risk. Some ETFs trade extremely lightly – the price difference between what you could buy the ETF for (bid) and the selling price (ask) could be drastic.
Lastly, Mutual Funds allow you to purchase and reinvest fractional shares, ETFs don’t.
@Mike: I’m glad your company offers both 401ks. I checked with some of my friends and they do not have that option.
I’m trying to rebuild my savings, so I recently started using an ETF for my taxable account. I’ve been using ShareBuilder’s automatic investment program, so it only costs $4 to buy. It’s worked well so far. Very little hassle to set-up and pretty user-friendly interface. I don’t have an IRA yet, still using the company’s plan to save and haven’t maxed it out yet. They offer both the 401k and the Roth 401k.
We’ve been using index funds, and recently qualified for Admiral Shares in one of our Vanguard accounts, which drives the costs even lower. That being said, I’ve considered converting to ETFs in our taxable accounts to reduce the tax hit due to year-end capital gains distributions. You can actually do this (at least at Vanguard) without taking a tax hit on the conversion (more info in a forthcoming post). The only downside is that you have to pay a $50 conversion fee.
My wife and I use both. My own IRAs are at Vanguard (entirely in the 2050 fund). And her IRA is at TradeKing (in Vanguard ETFs that round out our combined asset allocation to be more to our liking).