06) Exchange-Traded Funds: Index Funds Vs. ETFs

by · October 16, 2010

If you plan to follow a more passive approach to investing, the question that is most likely to come next is how best go about it-using index funds or exchange-traded funds?

Index Funds versus ETFs

Of the two, index funds are the older form of passive investment. That method has been around since the 1970s, while the ETFs only started back in 1993. The numbers for both are close, but ETF coverage is greater and as a result there are indexes that can only be tracked through the latter. There are also indexes that are better suited for an ETF.

Dividends

An index fund can immediately invest dividends or interest income. ETFs, on the other hand, have to wait for the dividends on a quarterly-basis.

Liquidity

When it comes to liquidity, the advantage is on index funds. The net asset value (NAV) for index funds can be acquired by the end of the trading day. ETFs suffer in different areas. Some lack liquidity resulting in a higher bid-ask spread. Other less popular ETFs won’t have the same arbitrage interest of the more popular ones. This can cause a wide difference in market prices and NAV.

Expenses
Index funds and ETFs both come with pros and cons when it comes to investing costs. One may favor the other in different cases. For example, buying no-load index funds will have no transaction expenses involved; ETF investors will only have to pay commissions to the broker.

Taxes

In almost all instances, the ETF beats the index fund when it comes to taxes. The former will have lower taxes because it does not need to sell securities when it is created and redeemed. Index funds will have to trade securities resulting in a capital gain that must be claimed on the income taxes of the unit holders.

Rebalancing

A portfolio of ETFs have to pay commissions to the broker when trading. Trading in board lots additionally makes it harder to get the exact weightings of each desired ETF. Smaller portfolios are more affected by this. An index fund investor, by purchasing fractional units, can get exact weighings. No-load funds are also free of transaction expenses.

Dollar-Cost Averaging

Dollar-cost averaging is not advisable to ETFs. Not only is it impractical but it is very costly to implement since purchasing odd-lot shares involves a lot of commissions and other expenses. Mutual funds are better suited for this kind of technique.