ETF Index Funds and traditional index mutual funds often compete for lowest annual cost (expense ratio). Smart investors that contribute a monthly portion of each paycheck are generally better off with mutual funds. After learning how to invest, ETFs, handled correctly, can often be a near equivalent alternative. ETFs have additional trading costs from broker commissions and bid-ask spread costs. But for this cost, ETFs offer some extra flexibility. In the long run, most investors may find traditional mutual funds most cost effective. Whatever you buy, take the time to understand all costs and the frequency of your transactions.
Summary of video: ETF Index Funds
Key points from video:
- At Vanguard, ETFs and traditional mutual funds are virtually identical. Each may have a cost advantage over the other, depending on the amount invested.
- But ETFs have additional costs since they’re traded on an exchange. So add potential commission costs and bid-ask spread costs for each transaction.
- For that extra trading cost, with ETFs you get the ability to trade throughout the day at the intraday prices. It’s arguable whether this is useful to investors, but some like the price certainty.
- If you are investing regularly (say from every paycheck) or withdrawing regularly (perhaps in retirement), then the traditional mutual funds avoid those transaction costs and may be best.
Transcript of video: ETF Index Funds
Elizabeth: Guys, we’re actually going to switch gears a little bit here with a question from Bill in Danville, Virginia. He’s asking, “What are the pros and cons of index investing through mutual funds versus using ETFs, exchange-traded funds?”
Scott: I’ll take a shot at that. I like to think about the choice between an exchange-traded fund, or an ETF, relative to I guess what I’ll call a traditional mutual fund, or an open-end mutual fund. And the debate typically comes down to the fact that there are some I’ll call advantages to really each, but it comes down to the, what’s your preference for the structure to get the exposure that you’re trying to achieve? And if you think about ETFs these days, the overwhelming majority of them are index based, so if you’re going to compare an ETF, you’re usually or should be comparing them to an underlying corresponding index fund. So you look at the cost.
We’ve talked about how important costs are. Generally, the cost differentials between ETFs and traditional index funds are not that great. For instance, even at Vanguard we actually have traditional index products that are even lower than our ETF products, depending on the amount of money that you’re looking to invest. So, depending on those cost differentials, which are really not that big of a difference, the ETF offers an additional cost layer that you need to consider. They’re traded on an exchange, like a stock, potentially, so you could have commission costs, you could have bid-ask spread costs, the difference between what you’re going to buy it at, and then the difference of the cost of what can immediately sell it at. There is a cost there.
So those trading costs are over and above what a traditional index fund might employ, but, for that extra cost, you get additional trading flexibility in an ETF than you do a traditional mutual fund. What I mean by that is you have the ability to trade throughout the day or intraday at more of a known price than you do with a traditional index fund that closes at all of the values of all the securities or price at the end of the day, and you close at an NAV at 4:00. Throughout the day, the ETF is constantly trading and being valued, and you have a little more certainty as what the price is that you’re actually transacting at.
So, bottom line if you think about the differences, if you’re a person or an investor who wants to regularly invest money on an ongoing basis, making a lot of purchases as your dollar-cost averaging, or you’re selling a lot out of the portfolio, say in retirement, you know, incurring some of these extra possible costs in ETFs. Oover the long run I’d say a traditional index fund is probably going to be a little more cost-effective for those people making a lot of transactions over time.
Elizabeth: So, merits to both structures, sounds like the investor needs to know a little bit more about what they desire, how they’re going to be interacting, trading their products, and that will help them determine which, either index fund or ETF, works better for them.
Scott: For the most part, if you don’t have any inclination as to any type of an intraday trading capability, the traditional index fund is probably going to be the better vehicle for most individuals.
Footnotes and Credits:
This video is produced by The Vanguard Group and was uploaded to their YouTube channel Nov 6, 2014. I have created a summary and transcript to help you find the spots that interest you and make the best use of your time.
The Vanguard Group is the largest provider of mutual funds in the world. Of high interest: Vanguard is owned by the funds themselves and, as a result, is owned by the investors in the funds. Founder and former chairman John C. Bogle is credited with the creation of the first index fund available to individual investors, the popularization of index funds generally, and driving costs down across the mutual fund industry.