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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.
Conclusion
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.
{ 14 comments… read them below or add one }
Thanks. I’ve been wanting read more about the advantages and disadvantages with ETFs and index funds. I see advantages to both and with each of them you have to make sure you look at total cost. $8 a trade for ETFs might seem like a lot, but if you are giving up 1% for a non-index fund you could be losing much much more!
Thanks for going into detail about the fees and charges between index funds and ETFs. I went to an investing workshop months ago at my old job and the guys didn’t even explain this.
Sadly, most good index funds cough vanguard cough require an initial investment of $3,000. I’m just starting out, so I have to rely on buying ETFs (about $200-$250 a month). Once that gets to $3,000, I roll it into an index fund. Also, once you hit over $100,000, you get to a point where you would actually break even or save money if you maintain your own portfolio to match index funds (takes about 20 to 30 different stocks to completely diversify away risk, from what I remember). So, my personal path is ETFs to start, index funds in the middle, and my own stocks when I break $100k to $120k.
I would love to get more involved in investing . . . but I have no capital. Probably the best way for someone like me to jump start a nest egg is to max out what your employer matches in your employer retirement plan. Even in a down market you double your money right away.
I tend toward indexing simply because I’m looking at the long term. In fact, I don’t think I’d ever buy stock when I was looking at a time-frame under 5 years (or longer). And it seems to me that the only advantage of ETFs is their tradability.
I’d thought, though, that one could automate investing in ETFs?
Hi,
Aren’t we missing a relatively big tax advantage of ETFs? I had thought, and I could be wrong, that ETFs do not have to capital gain distributions. Am I wrong about this?
Thanks.
Dave N
Rassah – that’s a good point about Vanguard’s $3k minimum which I conveniently glossed over.
Bottom line with low cost investing is that you have to know what the costs are, whether you buy etfs or index funds or both. The reality is that most investors have no idea what their costs are.
Dave – ETFs most certainly do have capital gain distributions. If the underlying stocks pay a dividend (of any type) then the ETF does as well.
Dave N., you are right. I am surprised nobody else caught on. With ETFs just like with stocks you only pay capital gain taxes when you sell with a gain. No capital gain distributions. With mutual funds you get those even during bad years.
Personally, I mostly have mutual funds in the “equities part” of 401K , but I have mostly ETFs and individual stocks in my taxable account – again the part that I have in stocks; I have a considerable percentage of my money outside of the market in both retirement and non-retirement funds.
I should clarify about the cap gains – in theory ETFs should have little or no capital gain distributions. This would also be true of a mutual fund that never sold any holdings.
In practice – a broad-based ETF, say based on the S&P500 should be pretty stable but there are also a lot of more specific ETFs as well as ETFs that operate on some sort of automated strategy (ie dividend yield metric). The specific or partially managed ETFs are more likely to have capital gain distributions.
I don’t think the tax efficiency is all that relevant when comparing an index fund to it’s equivalent ETF since they should both have similar tax situations.
The fact is that you have to know what you are buying – “ETF”, “mutual fund”, “index fund” are just general labels – there is a lot of overlap with respect to how they are run. There is no reason someone can’t start an ETF and just pick their favorite stocks. How is that different than a managed mutual fund?
Mrs. Micah – you are correct about buying ETFs with automated trades. Sharebuilder allows for this – I should have mentioned it in the article but I guess I don’t really consider them a “normal” brokerage. They are a perfectly legitimate choice for buying stocks however.
@Mike – you are right, I was wrong, there could be capital distributions with some ETFs. At least in terms of shares sold by the manager. However, there is a difference in how index funds and ETFs handle redemptions. In ETFs investors are insulated from the selling of shares by other investors in the fund. This is especially important in the market like we had last year.
That was really helpful. Thanks!
Thanks, this helped explain the difference(s).
Hi,
This is first time I have visited your site. Really Great, thanks for sharing information. If you dont mind, is there a chace that you can share with all your readers, what are you currently invested in. Exactly what percentage of ETF’s, stocks and T-Bills if any. Market in 2007 and 2008 combined lost almost 50% of its value. What are you invested in that you have not seen such impact. I will be really really looking forward to see, how your portfolio looks like.
Thanks once again for sharing your finances.