ETFs or Index Funds – Which is Better for the Passive Investor?

Bruce Hanks |

ETFs and index mutual funds are emerging as the investment of choice for investors who are discovering the virtues of passive investing. Not surprisingly they have both seen an explosion of growth and are especially popular choices for retirement plans and investors with a long time horizon. With all of the attention they are garnering comes the question as to which investment option can generate the best long term results.  While they both have similar the similar investment objective of tracking the performance of the underlying stock or bond index, they operate in distinct ways that can produce different results depending on your own particular investment objective.

A Difference in Costs

While cost shouldn’t be your only determinant for choosing one investment option over another, it certainly should be contributing factor.  One of the primary reasons both ETFs and index funds are growing in popularity is their relatively lower cost. A straight-across comparison between the two would show that ETFs generally have lower expense ratios than index funds, sometimes by as much as half. Where as an index fund might charge .15% (which, by the way is still a fraction of what many actively managed mutual funds charge), an ETF might only charge .07%.  Over time, the difference of .08% can add up especially as your fund value continues to increase. 

There is another factor, and that is transaction fees. If the purchase or sale of an ETF or index fund involves a commission, it is usually not factored into the expense ratio; so they have to be considered separately.  Many of the best index funds don’t include any sales charge if they are purchased directly. ETFs have to be purchased through a broker who will charge a commission or transaction fee. If you use a discount broker, the costs can be minimal, sometimes as low as $7 per transaction.  But, if you are accumulating units over time, as in a dollar-cost-averaging strategy, you need to be aware of the transaction cost.

Investment Size Matters

If you plan on investing a lump sum amount, over $2,500, then your investment size need not be a concern. Most index funds do require a minimum investment in that range (investment minimums may be lower for retirement plans). Depending on the fund, subsequent purchase minimums vary but can be as low as $25. There is no minimum purchase requirement for ETF units or shares. They are simply purchased on the stock exchange and any dollar amount may be invested. The only issue is what, if any transaction fees are charged on each purchase which could eat into your account value.

Tracking the Market

Both investment options are designed to track performance of an underlying index. The portfolios of ETFs and index funds are comprised of a basket of securities that, essentially, reflect the securities listed on an index with appropriate weightings for each of the holdings.  And, both are priced based on the fund’s net asset value (NAV) at the end of each day. This is done by dividing the total number of shares into the total value of the fund. 

Because ETFs are traded on the open market, their share prices are affected by investor sentiment which means that they can trade at a premium or a discount to the NAV. If investors are sensing a market upswing, they may trade up the share prices of an ETF, and, likewise, if their outlook is negative it could drive share prices below the NAV. Generally, the more widely traded an ETF is, the more in sync the market price is with the NAV. Some would argue that the fluctuation of ETF share prices will more closely reflect the funds actual value at any given time. One measure of an ETF is its monthly premium/discount percentage which will show you the funds share price history relative to its NAV. Funds with a share price history that diverges widely from its NAV average should probably be avoided.

The Taxing Issue

Both ETFs and index funds tend to be much more tax efficient than actively managed mutual funds because the portfolio turnover is very low. That means that there are fewer taxable capital gains that flow through to the investor. This is one reason why both investment options should be held outside of a qualified retirement plan. In the long run, ETFs manager have more tools at their disposal to increase their tax efficiency even more, but perhaps not so much that it gives them any tremendous advantage over index funds.

*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by Advisor Websites to provide information on a topic that may be of interest. Copyright 2022 Advisor Websites.