We are very lucky in the US to have such cheap investment options. The most expensive index fund in my portfolio is the Vanguard Extended Market Index Fund at an expense ratio of 0.30%, which is INSANE!
I have a choice between using Vanguard’s index funds or their ETFs, both at no transaction cost and very low ongoing fees, so it really comes down to weighing the pros and cons and making a personal choice between the two.
Keep in mind here that I am comparing purchasing Vanguard index funds through Vanguard to purchasing Vanguard ETFs through Vanguard Brokerage Services. If you try to purchase Vanguard ETFs through another broker, you may incur transaction fees.
Pro: ETFs generally have lower expense ratios than index funds.
Caveat: The most expensive index fund in my portfolio has an expense ratio of 0.30% or a cost of $9/year on a balance of $3,000. Its equivalent ETF has an expense ratio of 0.16% or a cost of $4.80/year on the same balance. That is a different of $4.20/year or $0.35/month.
Pro: ETFs can be traded at any time of day.
Caveat: ETFs can be traded at any time of day, which allows you to attempt market timing.
Con: You have to take into account the cost of buy/sell spreads for ETFs.
Caveat: You don’t have this with index funds, since purchases and sales of index funds are at the NAV (Net Asset Value) at the close of business every day.
Pro: There are no minimums for purchasing shares of ETFs.
Caveat: You can only buy whole shares of ETFs, which means that if you, say, want to buy into Vanguard Total Bond Market ETF, which is currently trading at $83.56/share and you had exactly $200 to invest, you would buy 2 shares and be left with $32.88 in cash. This also makes re-balancing trickier.
Con: You can’t set up automatic trades. You have to transfer the funds from your checking account to your money market account which is linked to your brokerage account and wait the 3-5 business days for the hold on the funds to be released before you can buy shares of your ETFs.
Pro: You can make automatic trades, both purchases and sales, to and from your checking account. The funds will be on hold, but you still acquire the shares before the 3-5 business days hold is up.
Con: Index funds have higher costs than ETFs.
Caveat: When you reach $10,000 invested in a specific index fund in one account (i.e. your Roth IRA or your taxable investing account), the expense ratios are the same as the ETFs, if the mutual fund you are investing in has the Admiral Shares class. All of the funds in my portfolio have the Admiral Shares class.
Pro: All purchase are made at the NAV, with no buy/sell spread like there are with index funds.
Pro: Index funds are super easy to re-balance since you buy fractions of shares and you can re-balance in one fell swoop (exchange), rather than having to sell/buy.
Con: There are minimums for purchasing shares of index funds.
Caveat: The minimum on Vanguard’s Target Retirement 2050 fund is $1,000 with the minimum on future contributions at $100 (same for all of the other funds in the series). I would say that until you have saved up $1,000 in a savings account such as with Ally or ING Direct, it’s not worth the hassle of purchasing ETFs anyways.
Personally, I have chosen to invest in Vanguard’s index funds over their ETFs. I tried their ETFs for a few months last year and I switched back because I realized that having to trade them during the business day, having to calculate exact numbers of shares to sell/buy, and not being able to set up automatic trades or direct purchases from my checking account was driving me bonkers. To me, the index funds are just so much more passive and have been working great.
Readers, do you use index funds or ETFs? Or both? How did you choose between them?