Investors seeking an index investment nowadays can choose to put their money into either conventional fund shares or exchange-traded funds (ETFs), but deciding which to pick may seem perplexing. Many similarities-and important differences.
In many respects, index funds and ETFs seeking to track the same indexes are much alike. Characteristics such as risk and return attributes and portfolio holdings should be nearly the same. In addition, both ETFs and conventional index fund shares are entitled to distributions of income and capital gains.
But there are some important differences, primarily involving their trading features and pricing structures. So before you invest, you should ask yourself both how much you value flexibility-such as the ability to trade throughout the day-and how much you are willing to pay for it.
ETFs offer trading flexibility
Because they are priced-and traded-throughout the day on an open exchange, ETFs offer many features not available with conventional fund shares. For example, ETF investors can employ many of the same sophisticated trading capabilities that are used for trading stocks, such as borrowing against them.
The picture on costs is muddled
The question of costs is not as clear-cut. ETFs generally have lower expense ratios than conventional fund shares. In some cases, however, the difference may be small or nonexistent. (For instance, the expense ratio for Vanguard Total Stock Market Index Fund Admiral™ Shares is 0.09% according to the fund’s latest prospectus, the same as for Vanguard Total Stock Market ETF. So if you qualify for Admiral Shares, there may be little or no expense-ratio advantage in choosing the ETF.)
Even when the expense ratios for ETFs are lower, the costs associated with trading them can erase their expense advantage in some circumstances, so you need to think carefully about how you would manage your investment.
A tale of two investors
Here are hypothetical stories of two investors who have settled on index investing and now want to choose between conventional fund shares and ETFs.
Scenario 1: John received a $25,000 inheritance from his uncle’s estate. John plans to invest the money for retirement, which is at least ten years away. He likes the trading flexibility available in the stock market, but also knows that he is unlikely to consistently add to or withdraw from the fund. A low-expense ETF could make sense.
Scenario 2: Kathy works in sales and receives bonus checks from her employer every three months. She regularly invests a portion of her bonus-usually between $300 and $1,000-in a retirement account. Once Kathy invests the money, she’s unlikely to make many adjustments. A low-cost conventional index fund could make sense.
Note: These illustrations are educational only and do not take into consideration your personal circumstances or other factors that may be important in making investment decisions. The illustrations are not a recommendation to buy or sell a particular security.
For example, how often will you invest? Every ETF trade incurs brokerage costs and a bid-ask spread (the difference between the offer and the sale price, essentially representing the market maker’s profit). Frequent trading therefore can rapidly negate the benefit of a lower expense ratio. And if you plan to invest systematically, you’ll generally incur lower overall costs with conventional fund shares.
It’s also important to consider your time horizon-especially if you plan to establish a position for the long run and don’t intend to make periodic investments. The transaction costs associated with ETFs may initially make them more costly for smaller investments, but given enough time, the advantage of a lower expense ratio may outweigh those early costs.
Clearly, much depends on just how much advantage you might reap from the prospect of a lower expense ratio for ETF shares. So be sure to look carefully at the difference in expense ratios between the conventional shares and the ETF. If the difference is large, the ETF might be a better choice even if you are investing systematically, for example.
A final cost factor to keep in mind: To invest in ETFs, you’ll need a brokerage account, which could entail miscellaneous costs (such as account fees) that aren’t directly associated with buying or selling the ETFs. Even if all else seems to favor ETFs, these other costs, over time, could eat into that perceived advantage-so make sure you know what your brokerage would charge.