Given the choice between two funds – an index fund vs ETF – that meet the same goal, costs are a big deciding factor. The same principle works for the active vs index argument too. Why pay more for something when you get the same results for less somewhere else.
I think we can agree that low costs matter. Once you decide on an all index portfolio, the next step is picking between similar index funds and ETFs. Both do the same thing, for the most part. So is one better than the other? Are there other factors to consider?
Index Fund vs ETFs Cost Debate
There are a number of ways to build a portfolio. For this exercise let’s use a sampling of asset classes to build two portfolios around – one with index funds and the other with ETFs.
Index Fund Portfolio
I used Reuters (or pick one from this list of fund screeners) to find the best index funds for each.
- Large Cap – FUSEX (0.10%)
- Small Cap – NSIDX (0.15%)
- International – FSIIX (0.20%)
- Emerging – NOEMX (0.30%)
- REITs – VGSIX (0.24%)
- Bonds – VBMFX (0.20%)
These index funds have a minimum initial purchase requirement of $3,000 or less. Other funds are available with higher minimums that would cut these costs by half.
ETF Portfolio
I used ETFdb (in this list of ETF screeners) to find the best ETFs for each.
- Large Cap – VOO (0.05%) or IVV (0.07%)*
- Small Cap – VB (0.09%)*
- International – VEA (0.09%)*
- Emerging – VWO (0.15%)*
- REITs – VNQ (0.10%)*
- Bonds – AGG (0.08%)* or BND (0.08%)*
* commission free ETF at TD Ameritrade
How Much Do You Save?
The table below shows a rough estimate of the annual costs for the two portfolios:
| Annual Cost on $100,000 | |
| Index Funds | $198 |
| ETFs | $93 |
That’s a whopping $105 difference. Some ultra frugal types might argue it’s worth it. It’s not. That’s like clipping coupons when you’re already getting 90% off. Over a long enough period that difference compounds into the cost of a vacation. Or you can splurge on dinner out once a year.
If you have to save that $105 a year, don’t make any bad decisions with those ETFs that turn a meager savings into major losses. In other words, don’t put so much emphasis on costs that your choice between index fund vs ETF conflicts with your behavior.
Choose Index Funds because…
- Meet the minimum purchase requirement
- Don’t need to buy or sell during the day
- Avoid NAV (Net Asset Value) discrepancies
Choose ETFs because…
- Can’t meet the index fund’s minimum initial purchase requirement
- Need to buy and sell during the day
- Prefer limit orders over market orders
- More tax efficient (arguably, but not relevant in retirement accounts)
- For more advanced strategies like short selling, options, or NAV arbitrage
Summary
Cost savings is the biggest argument for ETFs. There are transaction fees and commissions to consider. But as I showed above, online brokers offering commission-free ETFs help avoid those extra costs. It’s why I use TD Ameritrade for my IRA. Once you meet the higher minimum requirements for lower cost index funds, the cost difference is negligible.
The biggest knock against ETFs is the instant gratification from buying and selling. I agree. It’s not for everyone. Especially those investors who suffer from sudden fits of trading. If you think that describes you, stick with index funds and maybe look into a financial advisor.
Seriously though, index funds or ETFs, which is it? Behavior is the deciding factor.
Costs have dropped so fast that it’s practically irrelevant. Choose the one that best fits your behavior and needs, then build a portfolio around that. If you know you’re susceptible to rash decisions at the worst possible times, then go with index funds.
But if you can handle the madness of the markets while avoiding big mistakes, then either one works. Because how you’re wired impacts your results far more than the minor cost difference between similar index funds and ETFs.
