ETFs or Index Funds: An Epic Battle

ETFs (exchanged traded funds) and index funds. The comparison between the two is kind of like deciding to pull over to a restaurant that you see off the side of a road in a region of the country youre not familiar with. If its called Marcos, the chances are that its Italian and it has some pasta, marinara, alfredo, and garlic bread inside. In much the same way, if you see an index fund and an ETF that track the S&P 500, you can reason that each is going to have some large, well-known U.S. based corporations inside.

However, since youve never eaten at Marcos, youre not sure what type of dining experience awaits, how much it will cost, or what kind of gastric issues youll have afterwards. These differences are going to take a bit further explanation.

3. Cost

• Index Funds: Cost whatever the broker charges to get into that fund and any loads charged by the fund company, plus an ongoing expense ratio that is typically higher than its ETF counterpart. For instance, while the Vanguard REIT ETF (VNQ) has an expense ratio of 0.10%, the index fund tracking the same index (VGSIX) has an expense ratio of 0.20%.
• ETFs: Cost is whatever your broker charges to make a trade (buying and selling) plus an expense ratio that is typically less than its index fund counterpart.

4. Functionality

• Index Funds: Generally have much less functionality than ETFs. For starters, when you buy or sell you do it at the NAV price at the end of the trading day (you dont have an option). If you buy or sell during trading hours, you have no knowledge of what that price is going to be on your trade. Also, funds can be limiting in that many of them have high minimum and subsequent investment amounts when purchasing.
• ETFs: Much more functionality. You can make any type of trade that you are able to make with regular stocks, including limit orders, short selling, etc. Meanwhile, you set the price and can trade at any point during the day.

5. Tax Efficiency

• Index Funds: When you own a mutual fund you are often forced to pay capital gains taxes every tax year, even if you dont sell any shares. Bummer, right? This is because any taxes are passed on to you when a fund sells a security for a gain.
• ETFs: The structure of ETFs tends to cut down on capital gains taxes that fall on you. However, you may end up paying capital gains taxes when you sell anyways. In general, ETFs are said to have less of a tax burden, but I couldnt find any quantifiable data behind this (if you can, please post in comments).

Conclusion on Index Funds Vs. ETFs:

If youre not sure whether to go with an index fund or its ETF counterpart, your line of thinking should probably go something like this: