Basics: When ETFs Beat Index Funds

It’s a bit of inside baseball in the money management world, but some advisors lean toward using index funds for their clients and some prefer exchange-traded funds (ETFs).

We use ETFs at MarketRiders, but we use ETFs that act and work like index funds. These are the widely held ETFs that track the big indexes that make up a portfolio: U.S. stocks, bonds and foreign indexes, as well as commodities and real estate.

Why not use index funds instead? Cost. If you own index funds created by your brokerage firm, it very often will be free to you to buy and sell those funds. No harm, no foul.

But if you have your money at one broker, say Fidelity, but buy and sell index funds created by anyone else, well, that will cost you. Often, it’s $50 each way, buying and selling. It adds up.

Depending on your broker, you will be able to buy and sell most index-style ETFs commission-free. Those that do charge a commission you will find are much less expensive to trade, perhaps $7.95 or less. If you have a large balance in your retirement plan, perhaps nothing at all.

Thus, if you know that the eight or 10 index funds offered by your brokerage are exactly what you need, go for it. However, if you like the idea of taking advantage of a mix of fund providers, ETFs are the far better choice. Cost is how ETFs beat index funds.

You’ll want to rebalance from time time. That’s when a widely held, inexpensive ETF really shines. You can buy and sell the funds at no or little cost and do so any time of the day. An index fund holder must accept the daily closing price, whatever it might be.

Own the market

We love index funds and believe that workplace 401(k) plans should use them extensively. If you are in an IRA that you must direct yourself, however, the choices are less clear.

Both types of investments do the same thing the same way. They allow you to “own the market” rather than attempting to get in and out of specific stocks. They both allow you to own a long-term portfolio rather than encouraging short-term trading habits.

However, if you are a do-it-yourself investor and like granular control and lower costs to boot, then ETFs are the best way. That’s why we recommend them to our own clients for their portfolios.