For investors who have only recently decided to switch their portfolio to low-cost, indexed investments, one of the questions that must be answered is whether to use ETFs or traditional index funds. We discussed this issue a couple of years ago here on the blog, but many things have changed since then.
Two years ago, arguably the biggest factors in the decision were that ETFs had lower expense ratios than most index funds, but you had to pay a commission to purchase them. Since then, however, multiple brokerage firms (most notably, Vanguard, Fidelity, Schwab, and TD Ameritrade) have begun to allow for commission-free trades of certain low-cost ETFs.
On the other hand, ETFs no longer offer much (if anything) in the way of savings with regard to expense ratios. If you have $10,000 or more to invest in a given fund, you can have access to the “Admiral shares” version of most Vanguard funds, which usually have expense ratios as low as the lowest-cost ETFs. (Prior to October 2010, the Admiral shares had a minimum initial investment of $100,000 rather than $10,000.)
In short, when it comes to expenses, there is no longer a significant difference between the lowest-cost ETFs and the lowest-cost index funds.
Much has been written about the difference in tax-efficiency between ETFs and traditional index funds. Some people argue that ETFs have lower tax costs, while others argue exactly the opposite. As far as I can tell from comparing Morningstar’s “tax cost ratios” for several index funds and comparable ETFs, it’s not entirely clear which side of the argument is correct.
What is clear though is that both index funds and passively managed ETFs are far more tax-efficient than the majority of their actively managed counterparts — primarily due to the fact that passively managed funds have much lower portfolio turnover than actively managed funds.
More Important Considerations
For most investors, because of the industry changes in recent years, the ETF vs. index fund decision now comes down to considerations other than costs.
It makes sense to use ETFs if you care about:
- Buying or selling your holdings in the middle of the day, or
- Using types of orders other than market orders (limit orders, for instance).
Conversely, it makes sense to use traditional index funds if you care about:
- Being able to buy fractional shares, or
- Setting up automatic purchases (or sales) at regular intervals.
Personally, I don’t particularly value the advantages offered by ETFs, so I choose to use traditional index funds. For other investors, ETFs will be a better fit.
In any case, for investors using a “buy, hold, and rebalance” strategy, the differences between low-cost ETFs and low-cost index funds are slim. Your long-term success is unlikely to be affected either way as a result of the decision.