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As a followup to yesterday’s post about mutual funds, I thought I’d talk today about the merits of exchange traded funds (ETFs) vs. low cost index funds. Which is a better choice and why?
What are index mutual funds?
Index mutual funds are simply mutual funds that track a market index such as the S&P 500, Wilshire 5000, or Barclays US Aggregate Bond Index. Fund management is totally automated, so the expense ratios are much lower than for most actively managed funds. In fact, in most cases the expense ratios are less than 0.50%.
Like other mutual funds, index funds are typically bought and sold at the end of the day, which means that you don’t have a lot of control over the price at which you buy or sell. The good news is that, with few exceptions, you can buy them direct from the mutual fund company, so there are no brokerage fees.
What are exchange traded funds?
Like index funds, most ETFs are designed to track a market index of some sort. The main difference is that ETFs are bought and sold just like individuals stocks. This means that they’re traded throughout out the day, but you have to pay brokerage fees whenever you buy or sell. The good news here is that the expense ratios of ETFs are typically lower than for their index fund counterparts.
Are index funds or ETFs a better choice?
Before you make a decision, ask yourself a few questions:
- What are the exact costs for the ETFs and index funds that you’re considering? Fees can vary widely, so don’t just assume on type of investment is more/less expensive than other. Instead, make a direct comparison.
- How large is your investment portfolio? Some index funds require a minimum initial investment. If you can’t afford the minimum, you might want to consider purchasing an ETF. Then again, if you’re not buying large amounts, the broker fees associated with ETFs can kill you.
- How frequently are you going to be purchasing? Since brokers charge for buying and selling ETFs, you have to factor in the added costs. If you regularly invest small amount, you may do better with index funds. The cost of rebalancing is also an important consideration.
And above all, don’t get sucked in by the hype surrounding the latest and greatest investment products. For example, the newest trend amongst money managers appears to be offering ETFs with hedge fund-like like performances. Keep your eye on the ball and think long-term.
What about you?
Given the choice, would you pick index funds or ETFs for your investments?