A basic strategy of investing is to save a small percentage of your income each pay period and place the money in a security that should grow over time. Index mutual funds have long been a boon for such investors who wish to invest small amounts on a regular schedule.
Exchange-traded funds (ETFs), however, are another way for investors to gain broad exposure to the market without having to select specific stocks, and are often a more cost-effective way of making periodic investments. Let’s look at the factors that these investors should consider when deciding between index funds or ETFs.
- For investors looking to save a little bit each month or with every paycheck, exchange-traded funds (ETFs) provide a cost-effective way to implement your strategy.
- In many ways, ETFs are quite similar to index funds, and they are still suitable for investors who only have a relatively small amount to invest periodically.
- Compared to index mutual funds, ETFs today tend to be lower-cost, more liquid, and tax-effective.
Comparing Costs of ETFs vs. Mutual Funds
Both ETFs and index mutual funds offer investors the opportunity to invest in many sectors of the economy throughout the world. With a large and ever-growing number of ETFs and index funds available, the decision of what sector or sectors hold the most potential is important. After you have decided on the sectors in which you wish to invest, you can then narrow down your search to particular ETFs or index funds.
Once you have identified several potential ETFs and index funds that satisfy your investment goals, the next step is to compare the costs of those funds. There are several cost factors that you must consider; for the most part, ETFs come out ahead in each case.
Funds normally charge their customers fees based on a percentage of the total assets under management (AUM). Commonly known as the expense ratio, this charge covers the overhead of the fund, such as the salaries of the fund managers and all other operating and marketing expenses.
ETFs tend to have a lower expense ratio, as their costs of operation are lower by design. Over time, this cost differential, while small, can add up to a significant amount due to the power of compounding.
Your gains will inevitably be taxed. Index funds, especially the actively managed ones, incur taxable events for their investors when they sell shares of companies that they own for a profit, which can take place each year. As an owner of the fund, you must then pay capital gains taxes on any gains that are reported. Investors in ETFs do not incur any capital gains until they sell shares in the fund, when they may be liable for the taxes that they realize if the selling price is higher than their purchase price. This means that with ETFs, you are in control of when you incur a taxable event. Index fund investors will also face paying capital gains taxes when they sell their funds, assuming the fund increased in value.
Most index funds require their shareholders to open an account with a minimum investment. For instance, some Vanguard index mutual funds have a minimum investment amount of $3,000. Depending on the fund, the initial investment can be quite high. Also, many funds require investors to maintain a minimum investment level to avoid being charged a maintenance fee. ETFs do not have any minimum investment size.
The minimum that an investor must pay to buy an ETF is the price of one share of the ETF plus any commissions and fees.
Fees and Commissions
The primary disadvantage of ETFs is the cost to buy and sell the shares. Remember, you buy and sell ETFs like stocks. Depending on the broker, the costs can vary substantially. If you invest $100 per month, you will also be paying commissions and fees to a broker each month, which will hinder your returns.
Index funds may not charge a fee to buy their shares, even in small amounts, as long as you buy them from the fund company. Therefore, your monthly $100 is fully invested in the fund. However, the fund may charge an annual management fee to sell shares of the index fund. Other funds, especially those sold through a broker, may carry a commission known as a load.
When buying or selling any stock or ETF, there is a spread between the buying price and the selling price, which is known as the bid-ask spread. The wider the spread, the more the investment must grow to overcome the higher purchase price and the lower selling price. The spreads on ETFs depend on the liquidity and volume of trading, just like with any stock. Widely traded ETFs will have narrower spreads, while those that experience fewer trades can have large spreads.
Moreover, the buy and sell prices will vary throughout the day with the movements in the market. Just like buying stock, this moment-by-moment movement in the bid and ask prices can be an opportunity to acquire shares at a lower price. Of course, you could also end up buying at a higher price on the day if the shares of the ETF close down. If you are buying or selling ETFs, it is normally a good idea to use limit orders to give you control over your trade prices. Index funds, on the other hand, are priced at the close of the day, which is the price that investors will pay if they decide to buy them.
The Bottom Line
When making small, periodic investments, it is important to take a long-term perspective. First, decide what sector(s) you want exposure to. Selecting the right sector can make a significant difference in the performance of your portfolio. The cost associated with your investment is the next essential factor to evaluate.
ETFs have lower costs than index funds, but the cost to buy and sell shares can add up, as investors incur a transaction cost on each order to purchase and/or sell. These costs can lower the overall return of the investment. To lessen these transaction costs, investors should consider using a discount broker that does not charge a commission or possibly investing larger amounts fewer times a year, perhaps investing quarterly rather than monthly.
As more brokers shift to zero-commission trades, ETFs have become an even more attractive way to make periodic investments.