How To Choose Between An Index Fund And An ETF?

Answer 1

When choosing an investment for the core portion of your portfolio many analysts will recommend an index fund. Companies that offer index funds to investors are increasingly offering a version of the fund that is organized as an exchange-traded fund or ETF (Vanguard Total Bond Market Index Fund and Vanguard Total Bond Market ETF would be an example). While the underlying investments are substantially the same, there are enough differences between the two to make one advantageous over the other depending upon your circumstances.

There are two main differences between an index fund and an ETF – how they’re traded and costs.

An index fund is organized as a typical mutual fund. An investor can place a buy or sell order at anytime and that order will be completed at the next available close of business at that day’s closing price. ETFs, however, trade just like stocks. That means that an investor can trade throughout the day and have their trade executed at that moment’s prevailing price. If you’re looking for more control over when and at what price your trade gets executed, the ETF might be the preferred choice.

But that greater flexibility comes with a price. Many index funds are “no load” mutual funds which means they can be bought or sold without any commission charge. Since ETFs trade like stocks, they require a broker to execute the trade and that trade comes with a cost. The commission on an ETF trade can be anywhere from a few dollars up to $50 or more.

The underlying management expense of the two products is something you should also consider. ETFs tend to carry a slightly lower annual expense ratio than their mutual fund counterparts. If you’re choosing between the two and you’re looking to hang on for the long-term, the ETF may come out ahead in the end because of what you’re saving on management fees. Keep in mind though that you’ll need to weigh the commission cost of buying and selling the ETF against the management fee cost savings you’d experience to see exactly whether an index fund or an ETF will come out ahead in your situation.

In summary, total costs (management fee expenses plus commission costs) along with the time horizon for the investment will be the mitigating factors in if an index fund or an ETF is preferred. If you’re looking to trade frequently or have a short-term time frame, the lower fees involved with the index fund may be a better choice. The ETF, however, may net you an overall cost savings if you don’t plan on touching the investment for the long-term.