ETF’s or Index Funds: An Epic Battle
ETF’s (exchanged traded funds) and index funds. The comparison between the two is kind of like deciding to pull over to a restaurant that you see off the side of a road in a region of the country you’re not familiar with. If it’s called ‘Marco’s’, the chances are that it’s Italian and it has some pasta, marinara, alfredo, and garlic bread inside. In much the same way, if you see an index fund and an ETF that track the S&P 500, you can reason that each is going to have some large, well-known U.S. based corporations inside.
However, since you’ve never eaten at ‘Marco’s’, you’re not sure what type of dining experience awaits, how much it will cost, or what kind of gastric issues you’ll have afterwards. These differences are going to take a bit further explanation.
Differences Between Index Funds and ETF’s
1. How they Trade
Index Funds: Index funds are a type of mutual fund. You purchase shares from the fund management company. Index funds do not trade on the open market throughout the day. Share purchases can only happen once a day – at the close of trading.- ETF’s: Shares are purchased through a broker and are traded on the market throughout the trading day.
2. How they are Priced
- Index Funds: Are based on the fund’s holdings rather than a perceived value of that fund. Shares are priced based on their Net asset value (NAV), the same way all mutual funds are. Net asset value is (assets-liabilities)/shares outstanding.
- ETF’s: NAV is used to evaluate the ETF by investors and market forces (supply and demand) influence the share price through trading. When an ETF’s share price trades at too much of a premium or discount to it’s NAV, savy investors will typically come in to purchase or sell their shares, often-times bringing the price close to the NAV.
3. Cost
- Index Funds: Cost whatever the broker charges to get into that fund and any loads charged by the fund company, plus an ongoing expense ratio that is typically higher than its ETF counterpart. For instance, while the Vanguard REIT ETF (VNQ) has an expense ratio of 0.10%, the index fund tracking the same index (VGSIX) has an expense ratio of 0.20%.
- ETF’s: Cost is whatever your broker charges to make a trade (buying and selling) plus an expense ratio that is typically less than its index fund counterpart.
4. Functionality
- Index Funds: Generally have much less functionality than ETF’s. For starters, when you buy or sell you do it at the NAV price at the end of the trading day (you don’t have an option). If you buy or sell during trading hours, you have no knowledge of what that price is going to be on your trade. Also, funds can be limiting in that many of them have high minimum and subsequent investment amounts when purchasing.
- ETF’s: Much more functionality. You can make any type of trade that you are able to make with regular stocks, including limit orders, short selling, etc. Meanwhile, you set the price and can trade at any point during the day.
5. Tax Efficiency
- Index Funds: When you own a mutual fund you are often forced to pay capital gains taxes every tax year, even if you don’t sell any shares. Bummer, right? This is because any taxes are passed on to you when a fund sells a security for a gain.
- ETF’s: The structure of ETF’s tends to cut down on capital gains taxes that fall on you. However, you may end up paying capital gains taxes when you sell anyways. In general, ETF’s are said to have less of a tax burden, but I couldn’t find any quantifiable data behind this (if you can, please post in comments).
Conclusion on Index Funds Vs. ETFs:
If you’re not sure whether to go with an index fund or its ETF counterpart, your line of thinking should probably go something like this:
- Can I even afford to get into the index fund with how much I have to invest? If not, going with an ETF is a no brainer.
- Does the index fund provide the functionality I’m looking for (i.e. a short sale). If not, go with the ETF.
- Other than that, it is up to you to do an analysis on which of the two options is going to cost you less for how you plan on investing with it. Think about how often you will be purchasing more, how much your broker charges, and compare the expense ratios between the two.
Regardless of which you choose, I personally use and highly recommend Ally Invest and Vanguard for ETF trading.
Fund Versus ETF Discussion:
- Do you tend to prefer index funds or ETF’s? Why?
- What other reasons, pro or con, have you found for buying index funds and ETF’s?
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When I initially learned about ETFs, I liked the idea and thought it would be a great way to invest. I’ve since backed off, slightly. My understanding is that if I have a lump sum, say $10K (why is that always the magic number that is used to show growth…why not $1K or $100K) to invest, then a ETF would probably be the way to go. But, if I’m only doing $100/month, dollar cost averaging, then Index funds are better, mainly because of the brokerage fees associated with ETFs. I usually don’t invest lump sums, so I use the index funds. I’d love to hear other ideas.
I was researching funds for starting up my Solo 401(k). The ETF’s had one really good thing going for them: lower expense ratios. Depending which mutual fund I’m looking, the ETFs also have lower transaction fees ($9.99 on E*TRADE vs. $19.99 for regular mutual funds – but $0 for no fee mutual funds). I ended up going with mutual funds for one big reason though – E*TRADE won’t let me ‘DRIP’ an ETF. I’m not sure any brokerage will. Lack of dividend reinvestment is a deal-breaker for me. I’m also getting mostly no fee funds so that I have the option to dollar cost average years I don’t have the whole amount on hand at the beginning of the year. I prefer to invest annually, but if that’s not possible, I don’t want to be shelling out $9.99 per transaction.
Of course, if I only had an IRA or taxable account to work with, I would absolutely go for ETFs in an account with Zecco so I could make the trades for free!
I personally use both but generally recommend mutual funds. The problem I have with most ETF’s is the broker fee eats into a lot of tax/fee savings unless you’re investing a lot. So, if I’m doing a one time purchase on say 3k or more then I might do the ETF.
That said, if it’s something I plan to keep investing in then I typically go with the mutual fund. I almost exclusive use Vanguard for my funds. Yes, the minimum of 3k on most of their funds is high if you’re just starting to invest. Then again, if you don’t have 3k to invest you’re probably better waiting to save up a bit more versus trying to buy anything and paying the broker fees on it. Ah, but once you have the 3k you can buy any number of funds! For a first fund I would go with either an S&P or Total Market type fund, or maybe a target date retirement. After that initial 3k purchase you can now buy in some more in easy $100 bits without fees.
So, for most early investors I recommend saving up 3k, buying a broad fund, and then adding to it as you can. I find it a lot easier to save money mentally by simpling dumping a hundred bucks in every few days or weeks or whatever versus trying to save up enough to justify the broker fee on an ETF and ending up spending it on something as you wait.
Very good article. I think one thing to mention on pricing is that an institution will generally stand ready to correct prices in an ETF (Barclays for example, when talking about iShares ETFs), thereby making them even more efficient.
Good article. for someone who is unfamiliar with both types of funds, this was a good basic breakdown of them and their pros and cons. I really enjoyed how you did that. Thanks.
@Jacqui
TdAmeritrade allows you to DRIP. That is a major reason I am with them.
I have been using ETFs since January 2008. I set up an account with Sharebuilder. I can make monthly, automatic deposits to my account and set a price at which to buy automatically. The money in my account sits in a money market account until I accumulate enough. This way, I can practice dollar cost averaging but set my investment amount high enough to justify the $4.00 buying commission fee. I also have my account set up to reinvest my dividends, which is a nice feature.
A lot of new etfs have come on-line since this post was first published. However, trading the broader market etfs are probably still appropriate for most people. Trading the S&P 500 is easy with SPY. And, to save on trading fees, the big investment firms now offer their own brands of SPY. Schwab now offers an S&P 500 etf that incurs no trading fees.
For those who want to trade or invest a bit more aggressively, trading the “inverse” and “double” etfs can be the ticket. ProShares offers SSO for 2 times the return of SPY. For those who want to short SPY, SH is the inverse of SPY and SDS is the double inverse of SPY. These inverse etfs are perfect for retirement accounts where shorting is not allowed.
I have had good luck with the etf option. I watch my holdings closely and pay $7 for a trade. During those days when the market shoots up and an ETF may gain 4% I take what I need that week and pay my bills. When an ETF looks cheap but I feel it is a good group, I buy and that is usually when there is a 2% drop. I buy and sell during the day and so far, whatever the market is doing, I am making a profit. I don’t use anything but common sense and I like the way it is working.