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ETFs vs. Index Funds (revisited)

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.

Comparing Expenses

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.

Tax-Efficiency

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.

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Comments

  1. Mike,
    Nice summary. I moved a lot of my portfolio to ETFs a couple of years ago when costs were more of an issue than they are today, as you point out. One additional aspect of the ETF / Mutual Fund debate is in regard to “rebalancing.” I find it a little more difficult to rebalance using ETFs. With Mutual Funds, all one needs to do is move the dollar amount from one asset class to another if their portfolio gets out of whack with their desired asset allocation. With ETFs, you first need to sell from one ETF, have the money go to a sweep account and then buy into the desired ETF to get your portfolio back on target.

  2. Hi John.

    That’s a great point about rebalancing. Thank you for bringing it up.

  3. For investors with low balances, such as young folks with just a Roth IRA, commission-free ETFs make sense since you can’t meet the mutual fund minimums.

  4. One advantage of and ETF vs Index fund is if an investor wants the Vanguard FTSE international small cap index.

    By buying it as an ETF (ticker: VSS), you get a lower expense ratio (.33%), commission free thru Vanguard Brokerage, and avoid the purchase fee that is assessed by Vanguard, if it is purchased as a mutual fund share class.

  5. ETF’s bid-ask spreads widened substantially during the last liquidity crunch IIRC. If there is a big downturn and spreads widen on everything, I don’t care so much about the spreads on equity ETFs because I’m on the bid side of those. However, I’m selling bonds to buy those equities so am on the ask side there. For this reason, I prefer bond mutual funds over ETFs.

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