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April 19, 2014



Great Debates: ETFs vs. Index Funds

It’s been a while since I’ve done any Great Debates; for all the disagreement and squabbling about individual investments and the direction of the country that you hear, there’s a surprising amount of uniformity as to what constitutes sound investment advice. Invest early, invest often, don’t spend too much time and money trying to beat the market, just worry about keeping up with it; there, twenty-three words that sum up the greater bulk of good investment advice.

That said, the details do matter, and choosing the right investments is important, as well.  One issue you’ll need to resolve, even before sitting down to compare investments and choose the ones that meet your needs, is what investment vehicle to use.  There is a strong consensus among most financial advisers that the best way to invest is to choose well-diversified, easy to purchase investment vehicles that seek to match the performance of the broader market (or some defined segment of the market).

The two investment types best suited for such a plan include index mutual funds (or simply index funds) and exchange traded funds (ETFs).  They both have many of the same advantages, such as easy diversification, an index-following strategy, and low expenses.  But which is best for you and your particular purposes?  We’ll have to take a closer look at each type of investment to draw any conclusions.

Our Current Champion: Index Funds

Index funds are a type of mutual fund that doesn’t have its managers attempting to ‘beat the market’ by picking and choosing stocks (or other investments).  Instead, an index fund holds all (or a large representative sample) of the stocks in a particular stock index.  An S&P 500 index fund would hold all five hundred stocks from the index.  Each share of the index fund in turn represents a fractional share of all the stocks (or, as mentioned before, other investments) that are held, meaning that you would own a tiny, tiny piece of all the companies in which the index fund invests.  The advantages of index funds include:

-No trading costs: You can buy and sell shares of index funds without having to pay commissions or other fees on each purchase or sale.  (Although, if you are swapping the funds in a taxable account, you’ll have to pay taxes on any capital gains.)  As with all mutual funds, you can decide how much money you want to invest, and after the fund’s net asset value is calculated for the day, you’ll receive as many shares as you can purchase with your new contribution.

-Easy Automatic Investing: Most mutual fund companies allow you to set up investments for a particular amount that are enacted on the same date every month, allowing you to dollar cost average your way into a large fund position.  You might be able to do so through your brokerage (I know my preferred brokerage, Sharebuilder, makes automatic investing easy; I can’t speak for all brokerages though, whereas every mutual fund company worth its salt makes automatic investing simple).

Meet The Challenger: ETFs

ETFs are very similar to index funds, in that they are collections of stocks (or other… you probably get the picture by now) that are bought and sold as a single unit.  Unlike index funds or other types of mutual funds, though, ETFs are bought and sold on exchanges like the NYSE and NASDAQ, so they can be traded just like stocks.  This gives ETFs a few advantages over index and other mutual funds:

-Flexibility: Since you don’t have to wait until the end of the business day for the prices to update before you can buy and sell shares, ETFs give you many more options for when you can trade.  Furthermore, you can also do some of the more advanced techniques available to stock investors, such as shorting shares and buying on margin, for many more ways to use ETFs in your investments.

-Lower Expense Ratios: One of the advantages of index funds is that they are cheap; the expenses charged by the fund managers are usually under 0.50%, sometimes as low as 0.10%.  But the expenses of ETFs are even lower, frequently under 0.10% (at least for plain vanilla ETFs).  For example, the Vanguard Total Market Index fund has an expense ratio of 0.18%, while the Vanguard Total Market ETF has an expense ratio of 0.09%.  Same fund family, same underlying investments, but the ETF has half the expenses of the index fund.

-More Tax Efficient: Although index funds are known for being very tax efficient (there is much less buying and selling compared to actively managed funds, leading to fewer tax consequences), ETFs are even better.  Since they are created from a large number of stocks (or…you know) known as a creation unit and then sold, there are essentially no capital gains distributions, making them an improvement on index funds that have to pay out capital gains when they need to meet redemptions.

And the Winner Is…

Which should you choose for your investments?  Well, if you are an active trader, there’s really no option: ETFs are going to be your tool of choice.  That flexibility advantage is all you really need to know; attempting to jump in and out of mutual funds at the drop of a hat is a futile gesture, and the ability to perform more complex trades is vital to success as an active-trader.  (I would remind you that attempting to ‘beat the market’ is considered tough, if not impossible, by most commentators; just because ETFs are better for that purpose doesn’t mean you run out and become an active trader.)

If you are a buy and sell investor holding onto an investment for decades, on the hand, things get more complex.  As mentioned already, the expense ratios on ETFS are lower.  Going back to our Vanguard Total Market investments, the index fund will cost $18 a year on a $10,000 investment, while that same $10,000 would only ‘cost’ $9 with the ETF.  (This is an oversimplification of how expenses ratios work; the money is actually taken by very slightly lowering your investment gains or increasing your investment losses.  You’ll never get a bill or something similar asking you to fork out the expense ratio money, this is just to help you see the difference.)  It seems like the ETF is a no-brainer again, right?

Well, maybe; the other big expense for ETFs is the commission on buying and selling shares that will be charged by your brokerage.  If you happen to have a brokerage that charges absolutely nothing for your trades (such as Zecco.com, at least when certain conditions are met), then yes, ETFs will be the cheaper option.  Otherwise, the costs can quickly add up; buy some shares of the ETF once a month at a brokerage that charges $4 a trade, and by the end of the year, you’ll have spent $48 on top of the $9 from the expense ratio.  Suddenly, that $18 a year looks pretty good, doesn’t it?

If you’re looking to minimize your investment fees with ETFs, you’ll have to (a) limit the number of times you trade (to cut down on the trading costs, (b) invest larger amounts each time (so the smaller fees can counteract the trading costs) and (c) seek a brokerage with the lowest costs possible (a cheap brokerage, to say nothing of a free one, can make this calculation much more favorable to ETFs).  If you can do all of that, then ETFs will likely be your least expensive bet; if not, go with index funds.

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