One of the basic tenets 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 been a boon for many investors who invest small amounts on a regular schedule. Exchange-traded funds (ETFs) are another way for investors to get exposure to the market without having to select specific stocks. In many ways, they are similar to index funds, but are they suitable for investors who only have a relatively small amount to invest on a periodic basis? Let's look at the factors that investors should consider.
Comparing Costs of ETFs vs. Index 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 funds available, the decision of what sector or sectors hold the most potential is an important one. After you have decided on the sectors you wish to invest in, you can then narrow your search down to particular ETFs or 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 the funds. Three distinct cost factors favor ETFs, but there are also two important disadvantages to ETFs.
Funds normally charge their customers fees based on a percentage of the total assets under management. Commonly known as the expense ratio, this charge covers the salaries of the fund managers and all other operating 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. (For related reading, see: Stop Paying High Mutual Fund Fees.)
It's inevitable that your gains will be taxed. Index funds, especially the actively managed ones, incur taxable events for their investors when they sell shares of companies 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, at which time they may be liable for the taxes 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. Depending on the fund, the initial investment can be quite high. In addition, many funds require investors to maintain a minimum investment level to avoid being charged a maintenance fee. ETFs do not have any minimum fees. The minimum an investor must pay to buy an ETF is the price of one share of the ETF plus 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 be paying commissions and fees to a broker each month, which will hinder your returns. Index funds normally do not charge a fee to buy their shares, even in small amounts, as long as you buy them from the fund company. So, your monthly $100 is fully invested in the fund. However, management may charge a fee to sell shares of the index fund.
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 price 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 price 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 purchase and sell order. 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.