Index Funds vs ETFs

Which is Best? Index Mutual Funds or ETFs?

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••• Index funds or ETFs? See which is best for you and when you can use both. Terry Vine/Blend Images/Getty Images

Should you invest in index funds or should you use ETFs? Which is best? What are the differences between index funds and ETFs? What are their advantages and disadvantages? The short answer to these questions, as with almost every investing question, begins with two words: "That depends." There are strengths, weaknesses and "best use" strategies for each. Find out who should invest in either index funds, ETFs or both.

Similarities: Why Use the Indexing Strategy?

Before getting into the differences of index funds and ETFs, let's start with some similarities, or why you would invest in either an index fund or ETF. Index funds and ETFs both fall under the same heading of "indexing," because they both involve investing in an underlying benchmark index. The primary reason for indexing is that index funds and ETFs can beat actively-managed funds in the long run.

The first and best reason to use index funds or ETFs is for what the investment industry calls a passive investing strategy. Unlike actively-managed funds, passive investments are not designed to outperform the market or a particular benchmark index. The advantage here is that it removes manager risk, which is the risk (or the inevitable eventuality) that a money manager will make a mistake and end up losing to a benchmark index, such as the S&P 500.

Why Actively-Managed Funds Often Lose to Index Funds

A typical example is where a top-performing actively-managed fund does well in the first few years from inception; it achieves above-average returns, which attracts more investors; the assets of the fund grow too large to manage as well as in the past; and returns begin to shift from above-average to below-average.

In different words, by the time most investors discover a top-performing mutual fund, they've missed the above-average returns. It's what I call "chasing money;" you rarely capture the best returns because you invested based primarily on past performance.

Another advantage of investing in passive investments, such as index funds and ETFs, is that they have extremely low expense ratios compared to actively-managed funds.

This is another hurdle for the active manager to overcome, which is difficult to do consistently and over time. For example, many index funds have expense ratios below 0.20% and ETFs can have expense ratios even lower, such as 0.10% or lower, whereas actively-managed funds often have expense ratios above 1.00%. Therefore the passive fund can have a 1.00% or higher advantage over actively-managed mutual funds before the investing period begins. In summary, lower expenses often translates to higher returns over time.

Differences Between Index Funds and ETFs

Before going over differences, here is a quick summary of similarities: Both are passive investments that mirror the performance of an underlying index, such as the S&P 500; they both have extremely low expense ratios compared to actively-managed funds; and they both can be prudent investment types for diversification and portfolio construction.

As already mentioned here, ETFs typically have lower expense ratios than index funds. This can in theory provide a slight edge in returns over index funds for the investor. However ETFs can have higher trading costs. For example, let's say you have a brokerage account at Vanguard Investments.

If you want to trade an ETF, you will pay a trading fee of around $7.00, whereas a Vanguard index fund tracking the same index can have no transaction fee or commission.

The remaining differences between index funds and ETFs may all be considered aspects of one primary difference: Index funds are mutual funds and ETFs are traded like stocks. What does this mean? For example, let's say you want to buy or sell a mutual fund. The price at which you buy or sell isn't really a price; it's the Net Asset Value (NAV) of the underlying securities; and you will trade at the fund's NAV at end of the trading day. Therefore, if stock prices rise or fall during the day, you have no control over the timing of execution of the trade. For better or worse, you get what you get at the end of the day.

Advantages of ETFs vs Index Funds

ETFs trade intra-day, like stocks.

This can be an advantage if you are able to take advantage of price movements that occur during the day. The key word here is IF. For example, if you believe the market is moving higher during the day and you want to take advantage of that trend, you can buy an ETF early in the trading day and capture it's positive movement. On some days the market can move higher or lower by as much as 1.00% or more. This presents both risk and opportunity, depending upon your accuracy in predicting the trend.

Part of the trade-able aspect of ETFs is what is called the "spread," which is the difference between the bid and ask price of a security. However, to put it simply, the biggest risk here is with ETFs that are not widely traded, where spreads can be wider and not favorable for individual investors. Therefore look for broadly traded index ETFs, such as iShares Core S&P 500 Index (IVV) and beware of niche areas such as narrowly traded sector funds and country funds.

A final distinction ETFs have in relation to their stock-like trading aspect is the ability to place stock orders, which can help overcome some of the behavioral and pricing risks of day trading. For example, with a limit order, the investor can choose a price at which a trade is executed. With a stop order, the investor can choose a price below the current price and prevent a loss below that chosen price. Investors do not have this type of flexible control with mutual funds.

Should You Use Index Funds, ETFs or Both?

The index funds vs ETF debate is not really an either/or question. Investors are wise to consider both. Fees and expenses are the enemy of the index investor. Therefore the first consideration when choosing between the two is the expense ratio. Secondly, there may be some investment types that one fund may have an advantage over the other. For example, an investor wanting to buy an index that closely mirrors the price movement of gold, will likely achieve their goal best by using the ETF called SPDR Gold Shares (GLD).

Finally, while past performance is no guarantee of future results, historic returns can reveal an index fund or ETF's ability to closely track the underlying index and thus provide the investor greater potential returns in the future. For example the index fund, Vanguard Total Bond Market Index Inv (VBMFX) has historically outperformed iShares Core Total US Bond Market Index ETF (AGG), although VBMFX has an expense ratio of 0.20% and AGG's is 0.08% and both track the same index, the Barclay's Aggregate Bond Index. In different words AGG performance has historically trended further below the index than VBMFX.

Cautionary Words of Wisdom: Jack Bogle on ETFs

As you might expect, the founder of Vanguard Investments and pioneer of indexing, Jack Bogle, has his doubts about ETFs, although Vanguard has a large selection of them. Bogle warns that the popularity of ETFs is largely attributed to marketing by the financial industry. Therefore the popularity of ETFs may not be directly correlated to their practicality.

Also, the ability to trade an index like stocks creates a temptation to trade, which can encourage potentially damaging investing behaviors, such as poor market timing and frequent trading increases expenses, which is in contrast to the low-cost indexing philosophy.

Bottom Line on Index Funds vs ETFs

Choosing between index funds and ETFs is a matter of selecting the appropriate tool for the job and nothing more. A regular old hammer may effectively serve your project's needs, whereas a staple gun may be the better choice. Although these two tools are similar, they have subtle yet significant differences in application and usage.

Perhaps the best point to make about index funds and ETFs is that an investor can wisely use both of them. For example, you may choose to use an index mutual fund as a core holding and add ETFs that invest in sectors as satellite holdings to add diversity. When using investment tools for the appropriate purpose can create a synergistic effect, where the whole (portfolio) is greater than the sum of the parts.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.