Index Funds vs. ETFs

Which is right for you?

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There are strengths, weaknesses, and best-use strategies for both index funds and exchange-traded funds (ETFs). They're similar in a lot of ways, but there are subtle differences as well. Determining which is right for you depends on numerous factors and your own personal preferences, such as your tolerance for high expense ratios or preference for stock orders.

Similarities: Why Use the Indexing Strategy?

Both index funds and ETFs fall under the heading of "indexing." Both involve investing in an underlying benchmark index. The primary reason for indexing is that index funds and ETFs can often beat actively managed funds in the long run.

Unlike actively managed funds, indexing relies on what the investment industry refers to as a passive investing strategy. Passive investments are not designed to outperform the market or a particular benchmark index, and this removes manager risk—the risk or inevitable eventuality that a money manager will make a mistake and end up losing to a benchmark index.

Why Actively Managed Funds Often Lose to Index Funds

A top-performing actively managed fund might do well in the first few years. It achieves above-average returns, which attracts more investors. Then the assets of the fund grow too large to manage as well as they were managed in the past, and returns begin to shift from above-average to below-average.

By the time most investors discover a top-performing mutual fund, they've missed the above-average returns. You rarely capture the best returns because you've invested based primarily on past performance.

Factoring in Expense Ratios

Passive investments such as index funds and ETFs have extremely low expense ratios compared to actively managed funds. This is another hurdle for the active manager to overcome, and it's difficult to do consistently over time.

Many index funds have expense ratios below 0.20 percent, and ETFs can have expense ratios even lower, such as 0.10 percent. Actively managed funds often have expense ratios above 1.00 percent.

A passive fund can have a 1.00 percent or more advantage over actively managed mutual funds before the investing period begins, and lower expenses often translate to higher returns over time.

Differences Between Index Funds and ETFs

Lower expense ratios can provide a slight edge in returns over index funds for an investor, at least in theory. ETFs can have higher trading costs, however.

Let's say that you have a brokerage account. You'll pay a trading fee of around $8 if you want to trade an ETF, whereas an index fund tracking the same index might have no transaction fee or commission.

But the primary difference is that index funds are mutual funds and ETFs are traded like stocks. The price at which you might buy or sell a mutual fund isn't really a price—it's the net asset value (NAV) of the underlying securities. And you'll trade at the fund's NAV at the end of the trading day.

If stock prices rise or fall during the day, you have no control over the timing of execution of the trade. You get what you get at the end of the day, for better or worse.

Advantages of ETFs vs. Index Funds

ETFs trade intra-day, like stocks. This can be an advantage if you're able to take advantage of price movements that occur during the day.

You can buy an ETF early in the trading day and capture its positive movement if you believe the market is moving higher and you want to take advantage of that trend. The market can move higher or lower by as much as 1.00 percent or more on some days. This presents both risk and opportunity, depending on your accuracy in predicting the trend.

The Effect of the Spread...

Part of the tradable aspect of ETFs is the "spread," the difference between the bid and ask price of a security. The biggest risk here is with ETFs that aren't widely traded. Spreads can be wider and not favorable for individual investors.

...And Stock Orders

A final distinction ETFs have in relation to their stock-like trading aspect is the ability to place stock orders. This can help overcome some of the behavioral and pricing risks of day trading.

An investor can choose a price at which a trade is executed with a limit order. She can choose a price below the current price and prevent a loss below that chosen price with a stop order. Investors don't have this type of flexible control with mutual funds.

Should You Use Index Funds, ETFs, or Both?

The index funds vs. ETF debate doesn't have to be an either/or question. It can be smart to consider both.

Fees and expenses are the enemies of the index investor, so the first consideration when choosing between the two is typically the expense ratio. There might also be some investment types where one fund has an advantage over another. An investor who wants to buy an index that closely mirrors the price movement of gold will likely best achieve his goal by using the ETF called SPDR Gold Shares (GLD).

Finally, although past performance is no guarantee of future results, historical returns can reveal an index fund or ETF's ability to closely track the underlying index and thus provide an investor with greater potential returns in the future.

The 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 0.15 percent and AGG's is 0.05 percent and both track the same index: the Barclay's Aggregate Bond Index. AGG performance has historically trended further below the index than VBMFX.

Cautionary Words of Wisdom: Jack Bogle on ETFs

Jack Bogle, founder of Vanguard Investments and the pioneer of indexing, 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. The popularity of ETFs might not be directly correlated to their practicality.

The ability to trade an index like stocks also creates a temptation to trade, which can encourage potentially damaging investing behaviors such as poor market timing and frequent trading increases expenses.

The Bottom Line

Choosing between index funds and ETFs is a matter of selecting the appropriate tool for the job. A regular old hammer might effectively serve your project's needs, whereas a staple gun might be the better choice. The two tools are similar, but they have subtle yet significant differences in application and usage.

An investor can wisely use both. You might choose to use an index mutual fund as a core holding and add ETFs that invest in sectors as satellite holdings to add diversity. Using investment tools for the appropriate purpose can create a synergistic effect where the whole portfolio is greater than the sum of its parts.

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