Should I invest in ETFs or passive index funds?
I am opening a Roth IRA account through Vanguard and was wondering whether to invest in ETFs, or passive index funds? I'd like to choose an all ETF portfolio for their lower expense ratios, commission free trades through Vanguard and their ability of liquidity. However, my concern has to do with the long term holding strategy of an ETF while it is able to be sold short. Are their any other long term risks with holding an ETF portfolio? Would it make more sense then to pay a little extra in expenses and stick with passive index funds for that matter?
ETFs have a few disadvantages in my opinion. First, they trade on the market and can trade at premiums and discounts, which can easily wipe-out any difference in expense ratios (if there are any between similar funds). Similar to that point when you purchase a mutual fund you buy in at cost, whereas when you trade during the market you may not. Finally, ETFs are not as liquid as funds, and that often causes issues with trading, and being out of the market. ETFs trade T+3, and depending on the platform you may have to sit out that time before buying. Mutual fund proceeds are available the next day (assuming trades go in before close).
Mutual funds are more liquid, give a guaranteed cost, keep you invested while rebalancing, and are far easier to trade. ETFs have some benefits that can be useful, but overall I find funds are more appropriate for long-term investors.
There's no advantage to ETFs over index funds, especially when the ETF and index fund track the same index, like the S&P 500 or Total Stock Index. ETF proponents will claim they are more tax efficient (they aren't if you're looking at tax-efficient or tax-managed index funds) and your benefit from being able to trade more regularly (that's not a benefit, you should be trading as infrequently as possible). What's more, in market crises, we've seen some dislocations in pricing in ETFs, especially at market opens. Some ETFs are also thinly traded and you could pay hidden market spreads. With a mutual fund, you get the closing day's NAV, no matter what.
I don't own any ETFs, I am 100% in passive, index-like mutual funds, and I do this for a living, have a CFA, etc.
Eric D. Nelson, CFA