It’s no secret that minimizing costs is one of the best ways to improve investment returns. So it’s understandable that one question that comes up frequently is “which costs less: ETFs or index funds?”
For anybody new to ETFs: Exchange traded funds are simply passively-managed portfolios that track a given index, much like a traditional index fund. The difference is that they’re bought and sold like regular shares of stock rather than like shares of mutual funds.
For the most part, ETFs offer lower annual expenses than traditional index funds, but to purchase them you’ll generally have to pay a brokerage commission.
So which costs less overall?
Unsurprisingly, that depends on several factors. Generally, the greater the amount you’re investing, and/or the longer the expected holding period, the more attractive ETFs become.
If you have all of the relevant pieces of information, here’s a formula you can plug them into to get a decent comparison between an ETF and an index fund tracking the same index:
Future value of a sum invested = (PV – C) * (1+R-E)^T, where
PV = present value of initial investment,
C = brokerage commission,
R = expected annual rate of return,
E = annual expense ratio, and
T = period of time (in years) that you plan to hold the fund.
Example: Let’s say you’re planning to invest $400 this month in an investment that tracks the total U.S. stock market (as represented by the MSCI US Broad Market Index). You could invest in:
- Vanguard’s Total Stock Market Index (annual expense ratio of 0.18%), or
- Vanguard Total Stock Market Index ETF (annual expense ratio of 0.09%).
If you’re using TradeKing (as far as I know, their $4.95 brokerage commission is the lowest available for any low-volume investors) and we assume a pre-expense return of 8%, we can plug all the variables into the equation above to determine that your point of indifference will be roughly 14 years.
That is, if you plan to hold the investment for less than 14 years, you’d be better off with the index fund, and if you plan to hold it for greater than 14 years, you’d be better off with the ETF.
Applying this to your situation
In summary,
- the longer your time horizon,
- the greater the amount you’re investing, and
- the greater the difference between the expense ratios,
…the more sense it makes to use ETFs.
One last point of note: rebalancing comes with a cost if you’re utilizing ETFs, so the more frequently you plan to rebalance, the less cost-effective they become.
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{ 16 comments… read them below or add one }
All things being equal…..it certainly makes sense to stick with the ETF’s.
If you have a static allocation, I agree with all you say.
I personally feel, depending on your investment goals, you may want to be more active. I know you don’t agree with that…..
Being more active in the allocation process, I think funds could have a place in the portfolio – even if they are more expensive.
@Mike, one additional point in favor of the ETF: taxes on a year-by-year basis are deferred. The structure of the ETF allows them to not have to sell stock, and therefore recognize capital gains, when there is a redemption of shares as mutual funds must.
jb
Wow, a 0.09% TER for the total market fund. The main iShares equivalent for the UK market (LSE:ISF) has a TER of 0.4%! Makes you guys look spoiled for choice rather…
Wealth Pilgrim: Thanks for bringing that up. I tend to think in terms of a passive investing mindset. That’s why I only mentioned rebalancing. But yes, you’re of course correct: The more you plan to move your money around, the more the brokerage commissions involved with ETFs will cut into your returns.
Jim: I tend to see taxation as a separate topic from expenses, but they sure do both cut into returns! Thank you for mentioning the tax-advantaged nature of ETFs (over the already-tax-advantaged nature of index funds).
Monevator: Wow, that does make us look spoiled by comparison!
This article seems to imply that you don’t pay a commission for investing in an index fund. Is that true? How do you buy index funds?
Shorty: That’s generally (though not always) the case.
Most index funds are no-load, meaning that there is no commission to purchase them. For example, if you opened an account at Vanguard, there would be no commission to purchase Vanguard index funds.
Wow, that’s great. I had always thought no-load referred only to mutual funds. This changes everything! Index funds may make more sense in a Roth IRA than ETFs since you’re protected from the index’s tax disadvantages.
Shorty: You bring up a good point that within an IRA, the tax advantage of ETFs over regular, open-end index funds is irrelevant. As such, I think it comes down primarily to cost. Still–as per the above equation–many investors will be better off in ETFs.
Either way though, you’re in a much better position to succeed than you are with relatively high cost actively-managed funds.
Cheers,
Mike
Oh man. So now I not only get to think about brokerages and the right mutual funds to choose, but then consider how ETFs might positively affect my portfolio?!? My head is about to explode lol.
This article reminds me that investing is sort of a life-long learning process almost (unless of course you study it in college then it’s a much shorter time). Thanks for the eye-opener Mike.
Mike,
Two things you didn’t cover (and most people don’t when discussing ETFs) are the bid-ask spread and the NAV premium/discount that you’ll encounter when investing in ETFs. These create real, although hidden, costs that can severely dampen the benefits of investing in ETFs. Combine that with the commission costs and you’ll have a bigger hurdle to overcome. In my own analysis of all these costs, it only made sense to use ETFs if you were investing one large lump sum and wouldn’t be touching it for a long-time (including rebalancing). That’s just not a typical scenario for most investors. (Also, I was comparing Vanguard Index Funds to Vanguard ETFs.)
That’s why I only use and recommend index mutual funds myself instead of ETFs. I like the lower expense ratios of the ETFs, but you can’t ignore those other costs (bid-ask spreads and NAV premiums).
Hi Paul.
My thoughts on bid/ask spreads and NAV premiums mirror the following quote from The Finance Buff (originally from a discussion at the Bogleheads Forum):
“The question that really matters is whether the price paid is higher than the NAV at the end of the trading day, because the end-of-day NAV is the price you would pay if you buy a mutual fund on the same day. Is there any evidence that on average the ‘ask’ prices during the day are higher than the end-of-day NAV? I don’t think so. I’d expect that the price paid versus end-of-day NAV will even out over many trades.”
Mike,
The only problem I see there is that it is an assumption. Unless we actually look at the facts, we can’t know if The Finance Buff’s assumption is correct. With similar logic, I can expect that you could easily pay a far higher premium by trading throughout the day rather than just at the end-of-day NAV. Imagine if you’re buying while there’s a lot of hype about where the market’s going.
Of course, this could work the other way. Although it’s rare, you sometimes have the opportunity to buy ETFs at a discount to NAV. Then it could be far better to buy the ETF rather than an index fund. But those opportunities are quite rare and limited.
Paul,
Indeed. It is an assumption. I’ve been pondering how I might be able to find some actual data on how end-of-day NAV tends to compare to middle-of-day or beginning-of-day “ask” prices so that I could turn it into a post. Certainly seems interesting and worth discussing further.
Perhaps a project for this weekend.
Might be difficult to find that data unless you watch it through the day. Though you might have some luck with Yahoo! Finance. They have intraday prices for at least the last 5 trading days. Not enough for an extensive comparison though…
If you don’t work on it, I might for my own benefit. I haven’t talked much about investing on my new site yet, but I will be eventually.
Hi Mike
Found your site through getrichslowly.com and recently read your book “Investing Made Simple”…I have been reading quite a bit of information on your webpage as well, really soaking it all in. That being said, I know this blog post was written nearly a year ago, but with Schwab offering commission free ETF’s and such low expense ratios on Index’s that match that of Vanguard, wouldn’t ETF’s be a clearer choice now over Index Funds?
Hi Micah.
First, thanks for reading my blog and buying/reading one of my books.
As to Schwab ETFs, the no-commission policy certainly makes them look pretty good. The catch is that it isn’t a very broad offering of ETFs. Specifically, there are no bond ETFs, no REIT ETFs, and no small-cap value ETFs. To buy any ETFs in those asset classes, you’ll have to fork over an $8.95 commission.
So depending upon
a) the portfolio you want to build, and
b) the variables in the original article (how much you’re investing and the length of your expected holding period)
…ETFs via Schwab certainly could be a less expensive alternative than index funds at Vanguard. But that won’t be the case for everybody.