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With last year’s market meltdown affecting both managed mutual funds as well as their low-cost counterparts index funds and exchange-traded funds (ETFs), many investors are asking why they are paying extra money for managers who manage to lose just as much money as the passive instruments. They might also be thinking ahead to the good times when those same high fees will help reduce the managed mutual fund returns.
If you decide to jump into passive investing you may ask yourself a question common among investors, “Should I invest in index funds, exchange-traded funds, or both?”
There is no quick answer to this question. I think low cost index funds are the best choice for most investors and I will illustrate why in the rest of the post. First, let’s take a quick look at some important differences between index funds and ETFs.
What is an index fund?
An index fund is a mutual fund that invests in the same stocks that are contained in a stock market index, in the same proportion as the stock index.
Imagine a stock index that contains two stocks, IBM and Microsoft (MSFT). Let’s call it the ABC index. Let’s say that the ABC index consists of 60% IBM and 40% Microsoft. If an index fund is based on the ABC index then it, too, will invest in IBM and Microsoft, in the same proportion and allocation as index: 60% in IBM and 40% in Microsoft.
These percentages will change as the values of IBM and Microsoft change. If the price of the IBM stock increases and the price of Microsoft decreases then the index will change so that maybe 65% will be IBM and only 35% will be Microsoft.
What is an exchange-traded fund?
An exchange traded fund or ETF is an investment that contains the same stocks of a stock market index, in the same proportion as the stock index. If you are thinking this sounds a lot like index funds, you would be correct!
How index funds and ETFs are valued
The price of an ETF or index fund is determined by the value of the stocks contained in the underlying index. For example, the Vanguard Total Stock Market exchange traded fund (VTI) is an ETF that covers most of the stocks available in the US. As the price of the underlying stocks change value, the ETF price will also change because investors will bid the ETF shares higher or lower.
Differences between ETFs and index funds
One of the key differences between index funds and ETFs is that index funds are priced once a day. It doesn’t matter what time you put your order in, the price you get will be set at the end of the trading day (4:00pm EST). ETFs on the other hand are priced throughout the day in a similar fashion to stocks.
A second key difference is in order to purchase ETFs you have to pay a trading commission like you would with a single company stock.
Factors to consider when deciding between ETFs and index funds
Management expense ratio (MER). This is the basic cost of running an index fund or ETF. You won’t see the management fee deducted in any of your statements but you can find out what it is from the investment company website or Morningstar.com. Generally speaking, ETFs tend to be cheaper than a similar index funds however this can vary. It is very important to make sure you know the MER of any type of index fund or ETF you are considering.
Let’s look at an example. VTI contains all the publicly traded American stocks. The expense ratio is 0.07% which means that for every $10,000 of VTI you own Vanguard will charge you $7. Keep in mind this fee gets deducted directly from the fund. You don’t get charged separately.
The index fund counterpart to VTI is called the Vanguard Total Stock Market Index Fund (VTSMX). This fund comes with two different expense ratios.
- 0.15% if you have between $3,000 and $100,000. These are the Investor Shares.
- 0.07% if you have more than $100,000. These are the Admiral Shares.
From these numbers you can see that if you have less than $100,000 then the ETF version would be lower cost, but with over $100,000 the fees are a wash. But the expense ratio is not the only cost!
Trading costs. These are the costs associated with buying more units or shares of an index fund or ETF. Typically you don’t have to pay trading costs with mutual funds (index funds are a type of mutual fund), especially if it is a regularly scheduled purchase.
ETFs on the other hand need to be purchased through a brokerage so you will have to pay trading fees every time you make a purchase. There are some cheap options. For example, Zecco charges $4.50 per trade (or no fee if you have over $25,000 in your account) and TradeKing charges $4.95 per trade. These fees can add up, especially if you want to make more than one purchase per month.
If you consider both the expense ratio and the trading costs then the best choice really depends on the specific funds you are looking at as well as your trading costs. Usually you need a fairly large portfolio to be able to take advantage of the (usually) lower costs of ETFs. As a simple rule of thumb, if you have less than $100,000 in total you are probably better off with index funds. The Admiral series from Vanguard has great deals for index funds but you need a minimum of $100,000 per fund unless you want only one fund in your portfolio then you need some serious dough to be able to take advantage of them.
Automation of trades. One of the great advantages to index funds (and mutual funds in general) is that you can automate your purchases. If you want to contribute a certain dollar amount each month in a few different funds, automating that process allows you to “set it and forget it.” Once you set up the automated monthly purchases, money will be pulled from your bank account and the purchases will be made without any human intervention. This is the single biggest reason why I think that most investors should invest in index funds rather than ETFs if they make regular purchases.
Automation is a big issue for two reasons:
- Laziness is the enemy. If I have to log in and do some trades every month, once the novelty wears off then I will be sure to forget.
- Market timing. As a passive investor I know I’m wasting my time by trying to time the market. Regardless, every single time I’ve ever had to place an order for an ETF, I always try to time the market. I will sit there and watch the price movements for a while and see if I can get a better price. Once the order is finally placed then I’ll check back later to see if I should have waited a while before buying. This behavior is a complete waste of time but inexplicably, I do it every time. Buying index funds on a monthly purchase plan will save me a lot of time and stress.
Like many things in life, there is no clear answer to the question of whether index funds or ETFs are the better investment vehicle for you. Expense ratios, size of portfolio and frequency of trading are all important variables to consider, but I think for most investors, index funds are superior.
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Updated March 24, 2011 and originally published February 6, 2009. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @flexo on Twitter and visit our Facebook page for more updates.