Index Funds v. ETFs

Okay, let’s say that you have decided that indexing is the best way to invest. The next question is whether you should use index mutual funds or exchange-traded funds (ETFs). This is a good question and the answer depends on your particular situation. Let’s look at a couple of scenarios:

Dollar-Cost Averaging

If you are just starting out in the investing world, you are most likely investing a small amount on a periodic basis. This is known as dollar-cost averaging. One of the most important areas to consider when dollar-cost averaging is trading costs. In other words, you want to invest as cheaply as possible in order to keep costs from eating up your returns. Since you must pay a commission each and every time you invest in an ETF, an index mutual would most likely be a better deal.

One thing to keep in mind is that a lot of mutal funds have account minimums. I know Vanguard now has a $3,000 account minimum. This will require you to save up before you start investing.

Once your account is larger, you could consider using FOLIOfn. If you aren’t familiar with FOLIOfn, it is an online brokerage firm that charges a set fee for a certain number of trades. See the chart below:

FOLIOfn Pricing

For $199 per year, the Bronze Level plan allows 200 free window trades per month. If your goal was to keep your trading expenses to under 1% of your portfolio, you would need to have at least $19,900 with FOLIOfn ($199 ÷ .01 = $19,900). Window trades are done in-house by FOLIOfn. It is a process in which they try to match buyers and sellers internally rather than going out to the market. This process keeps prices lower. One thing I’m not certain of is the spread (the difference between buy and sell prices) that you would be charged.

Lump Sum Investing

Now let’s say you are leaving your company and have $100,000 to rollover into an IRA. This is a toss-up. Vanguard charges .1% (one tenth of a percent) for their Total Stock Market Index if your account is more than $100,000. Their Total Stock Market “Viper” ETF has an expense ratio of .7% plus you must pay trading fees because the ETF operates like a stock.

Of course, if you went the FOLIOfn route, you would pay .89% per year (.7% for the ETF + ($199 ÷ $100,000) = .899%), which is significantly higher than Vanguard’s TMI mutual fund. Keep in mind that the $199 is a fixed expense so the bigger your account grew, the smaller this expense would be as a percentage of your account. So, in theory, the longer you hold your account, the more advantageous the ETF becomes.

5 thoughts on “Index Funds v. ETFs”

  1. Another factor to consider is dividends. The Vanguard ETF is paying 1.69% and the fund pays 1.58% (theoretically they should be the same.) If you want to reinvest the dividends, it can be done very simply in a mutual fund with no additional fees. It is, however, costly to reinvest dividends in an ETF (you have to pay the transaction fee every time.)

    It’s also interesting to note that the ETF returned 6.31% for ’05 and the fund returned 5.98%. (all data from Yahoo! quotes.)

  2. Don’t forget taxes! EFTs are more tax efficient for the most part than index funds. Index mutual funds can incur capital gains annually, while EFT index fund don’t.

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