Choosing Between ETFs and Index Funds for Your Portfolio

Exchange traded funds (ETFs) and index funds both have their own merits and limitations. Determining which of the two investing strategies is best for your portfolio will depend on a number of factors as well as your personal goals as an investor.

An ETF is an investment fund that holds assets such as stocks, bonds, and commodities, and operates on the stock exchange. An ETF will typically track a particular index (or a group of indices) and accordingly design its securities basket.

Index funds, on the other hand, refer to a passive investment fund, which is not designed to outperform a specific benchmark index. Index fund investing eliminates the manager risk, and runs at a very low cost and low risk.

While many ETFs can operate with the same goal of an index fund, to track an index at a low cost, not all ETFs are set up to do this.

Differences between ETFs and index funds

To begin with, the trading costs of some ETFs can be  higher than those of an index fund. The assumption behind an index fund is that its lower expense ratio will ultimately provide a marginal edge in return to the investor over time.

For instance, if you open a brokerage account with a reputable firm such as Vanguard, you would be charged a trading fee (typically less than $10) if you wish to buy or sell an ETF. However, the Vanguard index fund that could be tracking the same index may involve negligible to no commission or transaction fee.

But the cost of managing is not the only difference. The main difference is that an ETF is traded like a stock, while an index fund is essentially a mutual fund.

When you buy or sell mutual funds at a particular price, it is not exactly a “price” that you pay. It is the net asset value (NAV) of the fund’s underlying securities. So, unlike a stock or an ETF, you are trading at NAV in an index fund.

Therefore, in an index fund stock price fluctuations during the day are unrelated to your trade execution. You do not control the timing of your trade (you cannot sell when the price is high, or buy when the price is low). You will get the NAV at the day’s end, for better or worse.

Advantage an ETF over an index fund

While the index fund offers very low operational costs and eliminates manager risk, the ETF comes with its own advantages. Just like individual stocks, you can trade an ETF intra-day. This gives you more control if you are an investor who wants to execute day trades to take advantage of price movements.

Stock market prices fluctuate significantly on most days, a fact which presents risk as well as opportunity, depending on your ability to anticipate daily price trends and trade with skill and discipline.

Consider the spread: The “spread” in an ETF refers to the difference between a security’s bid and ask price. Spreads in ETFs can be significantly wide because ETFs are not as extensively traded as stocks. This aspect of ETF trading may not be favorable for an individual investor.

Placing stock orders: With an ETF you are allowed to place stock orders, which could help neutralize some of the price fluctuation risks of day trading. A stock order means that you can place a limit order by choosing a price at which the trade is executed.

You can choose a price that is lower than the current price and place a stop order to prevent a loss if the price goes below your chosen price. An index fund does not provide you this type of trading flexibility and control.

Tax liability

Your tax liability while trading an ETF could be lower because the trade takes place between the open market and the investor.

The fund manager will not be required to sell off assets to raise cash, which means the chances of creating a capital gains liability are lower. Capital gains tax will apply to the transaction but will not take effect if you hold onto the shares.

In an index fund, on the other hand, the transaction occurs between you and the fund manager. Therefore when you want to liquidate your holding the trade will take in the market, which creates a capital gain or loss.

What works better for you?

As an investor, you don’t necessarily have to make it an either/or debate between ETFs and index funds.

You could diversify your portfolio by including both. Your first consideration should be the expense ratio because as an index investor your returns are directly affected by the amount of fees and expenses you pay.

Apart from the expense ratio, you should look at a particular ETF or index fund’s past performance to make your choice.

Although historical performance does not guarantee future outcomes, it can give you a fair idea of the ETF or the index fund’s track record of delivering returns better than or matching to the underlying index.

Jack Bogle’s skeptical view on ETFs

The godfather of indexing, the late Vanguard founder Jack Bogle, did not shy away from sharing his skepticism about ETFs. Bogle said that the growing popularity of ETFs may have more to do with marketing tactics than with real benefits.

While the ETF gives you the power to trade an index, it also opens door to the temptation to trade, Bogle said. This could defeat the whole purpose of index investing and leave investors vulnerable to market risks, behavioral weaknesses, and increased expenses.

Making a choice between ETFs and index funds for your investment portfolio is a matter of choosing the right tool for the job. And the right tool is the tool you are comfortable with. You could even use both, say, by putting your core holdings in index funds, then add ETFs as satellite holdings for diversity.

However, if you are relatively new to the world of investing or want a simple and inexpensive investment strategy with minimum decision making, index fund investing could be the right answer for you.