Index Funds versus Exchange Traded Funds (ETFs)

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.

ETFs

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.

Index funds

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?

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13 thoughts on “Index Funds versus Exchange Traded Funds (ETFs)

  1. Our portfolio fetches ~ 0.12% in fees and it is all index funds. We haven’t jumped on the ETF bandwagon yet, and have no plans to in the foreseeable future.

    One other thing is ETF’s are considered to be tax efficient through trickeration of exchanges opposed to actual sales. This prevents the fund from creating taxable events for the rest of the shareholders. Generally speaking, this difference is relatively small compared to a large index fund, but another consideration.

  2. Those are two of my biggest complaints of ETFs.- (1) Buying while the stock market is open (unless there is an order) and (2) buying in whole numbers. I’ve ditched buying ETFs and use Vanguard to buy individual stocks (e.g. Apple). I am loving Vanguard’s 25 discounted trades.

    • Buying while the stock market is open is less of a problem if you’re not in the Eastern time zone, but still annoying when I tend to do my re-balancing at night and/or on weekends and set up purchases days ahead of time in increments of $100, not the number of shares.

      I was actually quite surprised to learn that stock trades aren’t very expensive at Vanguard – their $7 fee is less than Schwab’s $8.95 fee!

  3. We bought some ETF shares for some of our short-term investments, when the funds we wanted were available as ETFs (also at Vanguard). That was just one lump sum going in and we are planning to sell in a couple years, no trading along the way. Our ongoing retirement contributions are with index funds for the reasons you listed.

  4. We have both. Back when we started I knew about ETFs but index funds weren’t yet very popular, so I have QQQ(Q) and DIA. Not much point to selling them to move into an equivalent index. We’ve also been limited as to what is available in our 403(b), so most of that is in Spartan funds. But we’ve gradually been moving new IRA money into Vanguard Target Date funds.

    • Most of my investments were in my Roth IRA, so it was pretty easy to swap back. I sold my taxable shares of VOO in late 2011 to raise more funds for my down payment, so now I am completely rid of the ETFs. When I put money back into taxable investments, it will be in index funds.

  5. We also have a few ‘left over’ ETFs but primarily use index funds. I don’t try to time the market so I don’t need to trade during market hours. The main reason I use index funds is because I add to many of our accounts on a monthly basis, a little at a time, and so I don’t want to pay ETF trading fees. Index funds at Vanguard work great.

    • If you buy Vanguard ETFs through Vanguard Brokerage Services, you don’t have to pay any trading fees on the ETFs. You can also buy Charles Schwab ETFs with no trading fees through Charles Schwab. I think there are a couple of other brokerages where you can trade specific ETFs for free as well, so trading fees can definitely be avoided if you prefer ETFs.

      I definitely have found that adding funds to index funds is far simpler though.

  6. This is a great list of pros and cons for both of these. I invest in both, but I just rebalanced my 401(k) contributions so that a higher percentage would go straight to an S&P index fund.

  7. I never actually knew what ETF’s were! I’ve googled it a number of times and not found answer I understood. This makes so much sense. I think I’ll stick with index funds like you, even though they do have a slighting higher cost ratio. I just don’t like the idea of having to buy whole shares of ETF’s. I’m all about passive simplicity.

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