Which is Better: Index Funds or ETFs?

There's an on-going debate between index fund investors and investors in exchange-traded funds (ETFs) over which is a better investment. Personally, I like index funds but I find such "discussions" comical. It's not that one investment is better than another -- it's which one is better in which situation -- that's the real question.

I recently found an article that addressed this issue head on. Here's what Kiplinger's had to say about index funds versus ETFs:

In recent years, a new kind of index fund has become popular. Exchange-traded funds (ETFs) are merely index funds that trade like stocks. Are ETFs better than old-time index funds? For a lump sum, a good ETF will be a tad cheaper. If you're investing small amounts every month or so, regular index funds are slightly better. But for most investors, the difference is microscopic. Both are good choices.

There you have it -- lump sum investing favors ETFs while dollar-cost averaging favors index funds. Even so, there's not much difference between them.

Personally, I favor index funds because I do invest month after month, year after year. I have money go automatically into my checking account, then to Vanguard, then to specific funds at Vanguard. It's set up to occur automatically, so I just "set it and forget it" (as they say on that annoying TV infomercial.) ;-)

Comments

[Eric G.]

Thank You for posting this FMF. I'm sick of hearing about this argument. You said it well, "It's not that one investment is better than another -- it's which one is better in which situation -- that's the real question."

It's obvious that both are good investment options depending on the situation.

Thank you and hopefully this is the last we'll hear about this debate. (Sarcastic Tone)

[Moneymonk]

Same was said in Bogleheads Guide to Investing ETF are good for lump sums

[Lazy Man and Money]

I was hoping to read about how Zecco.com might change the thinking. Presumably ETFs are good for lump sums because there are commissions involved with buying and selling. If commissions can be eliminated, then do they become the clear winner?

Is it even worth caring about if "winning" is such a minor difference?

[FMF]

"Is it even worth caring about if "winning" is such a minor difference?"

Maybe not. But if the difference is even a quarter of a percentage point -- it could be a big difference in the long run.

[Les]

The problem with ETFs is that you usually have to pay a brokerage commission to reinvest dividends as there has been no way to make a direct purchase without going through a broker. Index funds permit dividend reinvestment without a fee.

[MossySF]

If you have $100 / month to invest and you are using E-trade to buy ETFs at $12.99 per trade, that's a +13% expense ratio. If you have $1000 / month to invest and your commission is $8 at ScottTrade, that's down to .8%. So keep bumping the amount up and the commissions down and at some point, the ETF commissions+expense ratios match the index funds.

At this point, I'm doing more ETFs because I pay $0 commissions at Wells Fargo. This also lets me get into Vanguard "funds" that either are closed to new investors or have high minimums. For example, the Vanguard Energy Index fund has a requirement of $25K minimum while the Vanguard Energy ETF is just the share price + commission. I do have to wait until dividends and distributions build up enough to buy another whole share (as far as I can see, Wells Fargo does not have the DRIP option).

[Adam]

I still don't get it. Which one is better, ETFs or Index Funds?

[Joe]

Eric Haas has a good discussion of pros/cons of each on his website.