One question that often comes up when deciding on how to invest is the choice of investment vehicles. If you want to buy low cost investments then index funds and exchange traded funds (ETFs) are the best choices.
Most investors are better off with index funds for a number of reasons – however it really depends on the individual situation. Let’s take a look at some of the differences between these two investment types first.
Exchange Traded Funds – ETFs
- Lower ongoing management costs (MER).
- Higher trading fees.
- Manual orders (ie you have to sign in and order each purchase).
Index funds
- Higher MERs.
- No trading fees.
- Orders can be automated.
Since most investors tend to make purchases on a regular basis, the trading fees on an etf will quickly eliminate any advantage of the lower MER. This means that index funds are often a cheaper alternative.
Another factor is the size of portfolio – if the portfolio is large enough then ETFs might make more sense. The MER savings on a larger portfolio might outweigh the higher trading costs.
Keep in mind that not all ETFs are cheaper than index funds and trading and annual account fees can vary quite a bit between institutions.
Best solution
Most smaller investors (less than $100k) are likely better off with index funds because of the lower trading fees.
Larger investors have more choice – they can keep going with index funds, or switch to ETFs or perhaps own both.
Once you have a large enough portfolio, you can consider having the bulk of your portfolio in ETFs and then make regular contributions into index funds. This way you get the low MERs of ETFs and have cheap trades with index funds.
More information
Should I Buy ETFs Or Index Funds?
Thanks to Green Panda Treehouse (a personal finance blog) for this post suggestion.
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I’d love for you to create an article that describes the different index funds and how one might decide which ones to be in.
A post with concrete examples of when to choose one over the other would be great.
Say you choose one ETF and one index fund, discuss the fees and where you found them, and then “show your work” about how you calculated the expenses of each.
Great post and site!
What about QQQQ? It is an Index ETF – isn’t this an example of both?
Thanks for sharing information on ETFs and mutual funds! I’ve known about mutual funds for a bit,but ETFs were still mysterious to me.
Enjoyed this post a lot. Thanks!
Andy – QQQQ is the stock symbol for Investco PowerShares QQQ ETF. This is based on the Nasdaq-100 which is the largest 100 companies listed on the Nasdaq by market capitalization.
I’m not sure what you mean by an “example of both” – a security can’t be both an index fund or an ETF – it has to be one or the other.
I invest in both index funds and ETF’s. I wouldn’t have touched ETF’s before the arrival of Zecco.com, but with zero cost commissions ETF’s are suddenly cheaper than index funds for the small investor. A mutual fund companies last remaining advantage is automated investing. My ETF recommendations are VTI (total market index), VFH (vanguard financial ETF), and VQN (vanguard REIT). You can use yahoo finance to look at the differences between the ETF and the same vanguard index funds.
Step 3 – good point about Zecco – without trading commissions, ETFs are a pretty good deal. Don’t underestimate the power of automation.
One point about VTI and VFH for anyone else reading this – all the stocks in VFH are in VTI so you would only buy both if you want to own a higher proportion of financial stocks (ie banks) than is currently in VTI. VTI contains all the stocks on the US exchanges.
Hi ABC,
This explains why the TD e-series are so common for those with small portfolios right?
Thanks!
I live in Belgium, and want to start investing. Sadly there are no low-cost index funds offerings available like you have in the US (e.g. Vanguard). The only alternative are ETF’s.
As I am not very wealthy and want to minimize the impact of the transaction costs, I’ll only invest each three to six months, saving some amount to invest each period. This means I can kiss dollar cost averaging goodbye
Needless to say, I’m rather jealous of the possibilities for investing you have in the US. My hope is that through the competition between the online brokers the transaction costs will go down. Or that low-cost index funds become finally available to us, but I’m not very optimistic on this last one
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