by Ken Hawkins



In much of the previous discussion comparing mutual funds to ETFs, the merits of actively managed mutual funds are compared to the passively managed ETFs. In some ways, it is like comparing apple to oranges. They have entirely different characteristics. If a passive approach is desired, an investor should then consider how best to implement it - by using index funds or exchange traded funds.


Index Funds and ETFs
Index funds have been available in the U.S. since the 1970s; ETFs were first traded in the U.S. in 1993. Although the number of index funds and ETFs are close, ETFs cover about five times as many indexes. Some of the newer ETFs track some indexes that are more appropriate for an ETF structure than for an index fund. Consequently, an investor might only be able to track an index by using ETFs because there are no index funds available that can track that same index

Costs
ETFs and index funds each offer advantages and disadvantages for managing the costs of the underlying assets. In some cases, the difference in fees might favor one over the other. Investors can buy no-load index funds without incurring any transaction costs. Investors buying ETFs will have to pay brokerage commissions.

Tax Efficiency
In nearly all cases, the structure of an ETF results in lower taxes versus the equivalent index fund. This is because the way in which ETFs are created and redeemed eliminates the need to sell securities. With index funds, securities are bought and sold, although with lower turnover than a typical actively managed fund. These transaction will trigger capital gains that have to be distributed to the unit holders. (To learn more, read An Inside Look At ETF Construction.)

Dividends
The nature of ETFs requires them to accumulate dividends or interest received from the underlying securities until it is distributed to shareholders at the end of each quarter. Index funds invest their dividends or interest income immediately. (For more insight, read Advantages Of Exchange-Traded Funds.)

Rebalancing
An investor with a portfolio of index funds or ETFs occasionally rebalances the portfolio, selling some of the positions and purchasing others. A portfolio containing ETFs incurs commissions by buying and selling the ETFs. Because the investor typically trades in board lots, getting the exact weightings of each ETF desired is practically impossible. This is especially true for small portfolios. With index funds, an investor can achieve exact asset allocation weightings because the investor can purchase fractional units. No-load funds have no transaction costs. (For more on this topic, read Rebalance Your Portfolio To Stay On Track.)

Dollar-Cost Averaging
The technique of using ETFs for dollar-cost averaging - spending a fixed dollar amount at regular intervals on a portfolio - is generally impractical. The commission costs and the extra cost involved in buying odd-lot shares makes this strategy very expensive to implement. Mutual funds are a more suitable investment vehicle for dollar-cost averaging.

Liquidity
A lack of liquidity on some ETFs, resulting in an increase in the bid-ask spread, adds to the cost of trading ETFs. Also, the less popular ETFs are not likely to have the same arbitrage interest of other ETFs, resulting in a potentially larger difference between market prices and net asset value (NAV). Investors in index funds can always get the NAV at the end of the day.


Next: Exchange-Traded Funds: Equity ETFs »


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