ETFs vs. Index Funds: Which Are for You?

If  there’s anything the investment business loves, it’s a good marketing angle. And this is a business than can market like nobody else.

Growth stocks, value stocks, contrarian funds, macro plays, guru driven…you name it, the folks on Wall Street have thought it up and sold it to someone.

It’s a lot of effort to keep people interested in money. Like any arcane profession, investing has its fans and obsessives.

For most people, though, it’s a big yawn. They’d like to make sure their hard-earned savings grows safely, sure, but they really don’t want to know too much about how or why.

Such fundamental disengagement is the kind of force that allows for the Bernie Madoffs of the world to prosper, unfortunately. But there’s also something to be said for taking a hands-off approach.

For instance, research has shown that women do better than men at investing, in large part because they don’t get wrapped up in heated trading strategies. Frankly, they are less emotional about it.

Seeking to capitalize on interest in the hands-off approach, the investment business dreamed up the index fund. It promised to buy and hold a broad selection of stocks, usually an entire market (thus “index”) and help investors avoid the desire to buy and sell individual stocks.

So far, so good. But investors were looking for something even cheaper. And they wanted to trade those indexes more easily. Thus, 20 years ago, the exchange-traded fund (ETF) was born.

What is the major difference? These days, not as much as you might think.

The biggest difference is that index funds operate in the way all mutual funds do, in that they are priced at the close of the trading day based on the net asset value (NAV) of the underlying securities.

ETFs, meanwhile, are priced to the market all during the trading day. That means they are easier to buy and sell rapidly, if need be.

The downside of such flexibility is that there can be a spread between the “bid and ask” of an actively traded ETF, that is, you might not be able to sell it back into the market at the price you paid, even a minute later.

But the advantages of ETFs are very clear: They’re dirt cheap. The expense ratio of the cheapest ETFs is down around 0.04%. (Note the extra zero to the right of decimal there. We’re talking hundredths of a percentage point.)

Some of the cheapest index funds cost double that price or more. You might say, well, I’m losing money on the spread, right?

Maybe, but only if you expect to be buying and selling your ETFs willy nilly. The fact is, like our friend the highly composed female investor, you absolutely should not do that.

One might also argue that ETFs have turned into the high-risk marketing vehicle du jour. Also true, if you fall into the trap of trying to use ETFs to execute tricky macro strategies. Stories of “tracking error,” where an ETF fails to keep up with its target benchmark, even moving in the opposite direction, are legion.

ETFs booming

Yet that doesn’t happen with the really broad, widely held ETFs, the ones that follow the S&P 500 or the biggest parts of the bond market. Their benchmarks are well understood, their designs simple and liquidity alone acts as buffer against crossed signals.

In sum, you can and should consider both ETFs and index funds. Both provide exposure to important asset classes at a very low price point.

But the ETF business is booming for a reason: Ease of trading and very low cost can help even the most ordinary retirement investor build a nest egg that will stand up in the long run, come what may in the markets.