Are ETF’s Better Than Index Funds?

An ETF is a single security that represents a portfolio of stocks, bonds, or other securities that trade on a stock exchange. You can purchase shares of an ETF through a brokerage account.

Before I get everyone out there jazzed up on this topic, let me clarify that I’ll be discussing broad-market ETF’s in this post, like the Vanguard Total Stock Market ETF (VTI) vs. the Vanguard Total Stock Market Index Fund (VTSMX). There are a lot of ETF’s in the marketplace today, including ETF’s that focus on very small slivers of the marketplace. I’m not all that interested in discussing small slivers of a market that most of us shouldn’t pursue anyway.

Here’s a brief comparison of ETF’s and Index Mutual Funds:

• Both invest in the same securities, assuming they both track the same index like the Wilshire 5000 (for example)
• VTI Expense Ratio: 0.07%, VTSMX Expense Ratio: 0.15%. Vanguard does offer “Admiral” class shares that have lower expenses, if you have $100,000 or more to invest or have held your shares for 10 or more years and have a value of $50,000 or more)
• ETF’s requires a brokerage transaction fee for every purchase and sale, but index mutual funds usually do not
• Dividends can be reinvested easily with mutual funds, and partial shares can also be purchased. Dividends cannot be automatically reinvested with ETF’s to my knowledge, without paying another trade commission.
• ETF’s have bid/ask spreads, and mutual funds do not.
• Limit orders, selling short, and buying on margin are available for ETF shares (not that I recommend selling short or buying on margin).

The good news from my perspective is that ETF’s have lower on-going expenses and reduced taxable distributions. Provided that you’re investing for the long term and have and have a large enough sum of money to invest to overcome the commission for making the purchase, ETF’s appear to be the way to go.

So where is the break-even?

I calculated the break-even based on a variety of investment amounts and time frames. The chart shows the difference in expenses between the ETF and index fund. Therefore a positive number represents the savings achieved by investing in an ETF.

The results below do not take the bid/ask spread into account as this amount varies, but I’ve read that the spread is typically ~0.025% for ETF’s that hold U.S. securities, so the results below should still be reasonably accurate. In addition to using the expense ratios of VTI and VTSMX mentioned above, I assumed a $15 brokerage commission for each purchase and sale trade ($30 total to buy and then at a later date sell). Some commissions run less than this, and some more, but this seemed to be a reasonable estimate.

As you see can see above, investing $10,000 in ETF’s for one year doesn’t save you any expense dollars, because the cost of the commissions is not offset by the lower expenses of the ETF. Over longer time frames though, and at larger investment levels, the reduced cost structure of the ETF’s can add up to real money.

When all this is said and done, investing in an index fund is still a great idea with it’s minimal expenses and numerous other advantages. If, however, you’re in a position to invest a larger lump sum in an index fund, you should consider ETF’s.

If you’re really trying to squeeze every penny out of your investments, and you are working within a tax-advantaged account like an IRA or 401k, you could consider the following strategy:

• save up until you can purchase Vanguard’s Total Stock Market Index Fund. The minimum may be as much as $3,000 depending on the type of your account. Be sure to reinvest capital gains and dividends.
• Not counting the initial $3,000, continue to invest your savings in this fund until the value of the fund is large enough to overcome the commission of purchasing the equivalent ETF.
• Purchase the ETF, leaving the $3,000 in the mutual fund.
• Invest all dividends and capital gains (if there are any) from the ETF in the mutual fund.
• Repeat.

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