You probably already hear a lot about investing using an index fund vs. ETFs. Both are cheap, and both can be used to own whole markets.
Beyond that, things can get fuzzy. There are some very detailed breakdowns of the differences, largely on tax matters. And you can catch up on the specific advantages of ETFs at sites such as MoneyCrashers.com.
But let’s assume you are invested in index funds in your IRA or your workplace 401k. Why bother looking at ETFs? Here are a few reasons:
1. No commissions!
This is a biggie. If you happen to buy an index fund run by your own brokerage, the fee might be zero. But if you buy, say, a Vanguard Fund in a Fidelity or Schwab account, get ready to fork over some money, perhaps $50 each way.
If you are a set-it-and-forget person, that won’t hurt much. If you rebalance among funds frequently, though, it adds up. Meanwhile, ETFs are largely commission-free these days or cost very little, typically $7.95 a trade.
2. Usually more liquidity
Index funds are mutual funds. When you go to buy or sell, you will get end-of-day pricing. The price won’t be radically different from what you expect. But that’s no way to trade if you own several accounts and juggle five to seven asset classes among them.
Liquidity in an ETF means that if you go to sell it for $28 a share, you will get very close to $28, maybe off by hundredths of a cent either way. Not all ETFs are liquid, but the ones tracking the most common indices will be.
3. Typically cheaper to own
There’s been a price war among ETF providers that isn’t being echoed, yet, among index fund providers. A commonly used S&P 500 index fund these days goes for an expense ratio of 0.28%. A comparable ETF has an expense ratio of 0.05%. Quite a gap.
4. More choices
We would never advise that you buy some of the more esoteric leveraged ETFs on the market. Almost nobody needs to play the price of sugar minute-to-minute using an exchange-traded fund. Seriously.
However, it is nice that you can be invested in a variety of asset classes quite cheaply through ETFs. Index fund providers try to keep up with demand for mid-cap, specialty and real estate funds, but it’s just more attractive to many investors to have the flexibility of an ETF. Consequently, there are more choices.
5. Cash flow to you
If you buy an index fund, you won’t have to hassle with what to do about the incoming dividends. They get reinvested for you. For many long-term investors, that’s a feature.
However, if you plan to rebalance frequently using cash, ETFs are going to send you the money to invest as you see fit. Thankfully, you’ll be doing so mostly commission-free.