Investor's Decision: Exchange Traded Funds vs. Index Mutual Funds

For many years, mutual funds have been the bread and butter of the average investor, including holders of an IRA or 401(K) or the investor who simply has some money to put into equities but doesn't wish to select individual stocks. More recently, the trend has moved toward low-cost index funds that are designed to track specific indexes, such as the S&P 500, Russell 5000, Wilshire 2000, and others, and to reduce costs by removing the management aspect from the equation. Because even the best fund managers typically find it difficult to consistently beat these indexes, the low costs, diversification and routinely positive returns that they offer have made index mutual funds a popular choice.

Even more recently, however, a new type of investment has come on the scene that is starting to aggressively compete with mutual funds for investors' dollars, and a lot of the rhetoric surrounding these investments - referred to as Exchange Traded Funds or ETFs - indicates that they may be a better choice than low-cost index mutual funds. To better understand which option is right for you, we'll take a look at exactly what each type of investment actually is and the advantages and disadvantages of each.

Index Mutual Funds

Index mutual funds take the management aspect away and track, as closely as possible, a given index or exchange. With research and management taken out of the picture, fund expenses go down, leaving more to the investor. There is a wide variety of low-cost index funds available, and investors should essentially steer clear of any fund that has a high expense ratio. When more money comes into a fund, the manager - or computer program, as is often the case with index funds - simply purchases more shares of the requisite stocks in order to continue to track the given index. Purchases are made based on the Net Asset Value (or NAV) at the end of the day, pure and simple.

Exchange Traded Funds

Exchange Traded Funds, just like their index fund counterparts, also track indexes. The difference is that the stocks of individual companies that comprise a given index are bundled into an equity-like investment vehicle that is traded on an exchange, exactly like a stock. That means that those purchasing ETF shares can place orders for them throughout the day, and even use limit orders to make trades. Because they are traded on an exchange and share many of the attributes of individual equities, ETFs can also be shorted and offer underlying options as an investment opportunity.

Advantages and Disadvantages

One particular disadvantage of index funds is that, outside IRA or retirement plans, the minimum investment can be quite high. In some instances, this could be relatively low, but in others minimum investments can be as high as $50,000. For small investors, such minimums are prohibitive. ETFs, on the other hand, have no minimums, meaning that if you want to purchase a single ETF share, you can do so easily.

ETFs are, however, subject to brokerage fees. While there are many low-cost brokerage options, those who wish to dollar cost average with their investment by making monthly contributions will have to pay that brokerage fee each month. With index funds, investments occur monthly without charge, representing a cost savings for index funds when investing in this manner. With the advent of no-cost brokerages, this is overcome to an extent, but you will definitely have to choose such a brokerage in order to match the cost-effectiveness of dollar cost averaging with index funds. Also worth noting is that when purchasing ETFs, there is a hidden fee, i.e. - like individual stocks, ETFs have a bid-ask spread (the amount paid to the trader to execute the trade), so you'll pay a bit more than the actual price of the ETF at the time of purchase (and make less at the time of the sale) to pay someone to execute the trade.

ETFs also offer the ability to engage in more advanced investment and trading opportunities. While mutual funds of all stripes do not offer the ability to buy and sell options, ETFs have option chains in much the same manner that individual equities do. It is also possible to use ETFs to short a given index if you feel bearish on a given index or the market in general. Mutual funds, on the other hand, are almost by their very nature intended as longer term investments and do not offer options investing or the ability to short an index. For long term investors, including the average investor, this is not an issue, but it is worth noting that ETFs offer greater flexibility for more experienced investors and traders.

With mutual funds, dividends can be paid out, but many chose to simply reinvest them automatically. As with the dollar cost averaging scenario explained above, there is no fee for reinvesting dividends. With ETFs, on the other hand, dividends are simply placed, as cash, in a brokerage account, where you can then reinvest on your own, but with the requisite brokerage fees incurred. Know more about types of investments.

The primary advantage that ETFs purportedly offer is lower taxes. The reality, however, is that the tax advantages of ETFs is greatly exaggerated. While index funds may be forced to sell shares if investors decide to redeem shares, thus resulting in capital gains and, by extension, capital gains taxes, ETFs, by their very nature, have both a buyer and seller in every transaction. The result is that they are not subject to "forced capital gains." It should be noted however, that ETFs don't actually eliminate capital gains, but simply defer them until such time that the shares are sold. However, indexes change from time to time, and if an ETF is to properly track an index (which it must do), then such changes will result in buying and selling of shares and, thus, capital gains in the short term. The long and the short of the tax argument is that ETFs offer only minimal advantages over index funds from a tax perspective.

It is, of course, ultimately up to the individual investor to determine what he or she wishes to invest in, but for the "average" investor there is very little reason to invest in ETFs over index funds. Assuming a low cost ratio and management minimum investments, ETFs simply create a more active investment approach, something that many are trying to avoid. For those who do wish to be more active in purchase and selling, or who wish to short indexes or engage in options trading at the index level, ETFs may be a very good choice indeed.