Investing Basics: When ETFs Are Better Than Index Funds

As the offering of low-cost investment funds gets more and more competitive, confusion is bound to set in. Phrases such as “indexing” can get applied to funds and strategies that are anything but passive.

Inexpensive, passive  funds break down into two big categories: Index funds and exchange-traded funds (ETFs). Each has its own role to play in a retirement savings plan, so knowing the differences is important.

If you have all of your retirement funds in a single firm that offers index fund products, using them can be a very cheap way to retire. Index funds costs have shrunk dramatically, with expense ratios down to few hundredths of 1 percent.

ETFs are often equally cheap, but be careful. Plenty of funds that operate under the “ETF” banner are actually active trading vehicles with surprisingly high fees. Be sure to buy ETFs that truly index the market.

Why not just buy index funds? Here are some times when ETFs are better than index funds:

1. You  manage a portfolio yourself

Index funds are attractive if you hire an advisor to buy them on your behalf. Often, advisors have access to cheaper funds than do retail customers. They can avoid or negotiate away brokerage fees you would otherwise have to pay.

If you are planning to buy and sell a portfolio with a variety of asset classes inside it, ETFs can give you that exposure passively and do so at minimal trading cost, even free in the case of many broadly traded index ETFs.

2. You need access to alternative asset classes

If all you want is a split of 60% bond and 40% stocks, index funds are an easy choice. However, you might want to own a selection of real estate investment trusts, or a smattering of commodities, or have access to the foreign bond market.

The more esoteric the asset class, the less likely you are to find an index fund that follows that class closely. Mostly, index funds concern themselves with the biggest, most liquid markets, not international real estate. In those cases, an ETF is a better choice.

3. You trade enough to worry about commissions

Generally speaking, you should trade as infrequently as possible. However, rebalancing a portfolio sometimes requires that you sell off a portion of your gaining assets in order to buy those that have declined.

In a volatile market, this can happen repeatedly. If you have to pay brokerage commissions of $50 for each trade, well, that adds up. Since most ETFs trade commission-free, the solution is to buy them instead of index funds.

Lowering your cost of investing is paramount to ensuring a steady return that will compound your wealth reliably over the years. It’s the surest way to retire well and on time.