ETF or Index Fund? (4/14)

The article below explains the difference between ETFs and index mutual funds. Unless you are making small investments on a monthly basis, ETFs are typically the better choice.

See the Investable Benchmarks for a range of strategic ETF portfolios.

Buying an index fund? Is a mutual fund or ETF best for you

Elliot Raphaelson, 4/22/14

People interested in investing in index stock funds have two ways to do it: mutual funds or exchange-traded funds (ETFs). For some investors, mutual funds will be more advantageous; for others, ETF will be. I’ll discuss the similarities and differences below, so you can determine which is best for you. It may be that both forms of investment have a place in your portfolio.

How are index mutual funds and index ETFs similar? With each alternative, you are investing in a similar portfolio, representing the same underlying index. For example, if you would like the index to be the S&P 500, you could select either a mutual fund or an ETF. You could expect that the overall risk, potential returns and portfolio turnover to be similar. Distributions of income and capital gains can be selected with both alternatives.

How are they different? With an ETF, the shares are purchased and sold through brokers on a secondary market. The shares can be are bought and sold throughout the day at existing market prices. There are usually brokerage fees for every transaction (there are exceptions). The expense ratios are generally lower than for most mutual funds. (The expense ratio reflects the fund’s operating costs including portfolio management, administrative services, shareholder reports, etc.)

With ETFs, there are no restrictions with respect to frequent trading. Shares can be bought on margin and sold short (i.e., you may sell shares you do not own, anticipating a fall in the value, at which time you would then purchase the shares at a profit). You may utilize stop order (i.e., an order to buy or sell a security once the price has risen above or dropped below a specified price). You can use a limit order (i.e., an order to buy a security at no more or sell at no less than a specific price) or an open order (i.e., an order that remains in effect until it is either canceled by the customer, until it is executed or until it expires).

With mutual funds, you buy and sell through the fund company. The shares are priced once a day at the end of the trading day. There are restrictions on the frequency of trading. You may not buy on margin, nor may you use stop orders, limit orders or open orders. You may not sell mutual fund shares short.

Although the ETF has the apparent cost advantage of a lower expense ratio, that is only one element of the cost. For example, if you intend to reinvest some or all of the earnings and/or capital gains, you have to consider the brokerage fees associated with such transactions. If you plan to establish a monthly investment program, you have to consider the transaction fee associated with each purchase. In addition to the brokerage commission, there is a bid-ask spread associated with each purchase.

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