Low cost index tracking investing a lump sum, two sorts desired - one broad US index, say the S&P 500, and another a high dividend tracking fund. Ah hell, throw in an intermediate bond fund too.
For each which makes more sense, an ETF or an index mutual fund and why? Is it the same answer for each one or is the difference in how dividends are handled enough to tip one more in one circumstance than the other?
Thanks.
IMHO, if you intend to hold for the long term, an index fund makes more sense. The immediate tradeability of an ETF offers no particular advantage, and the index fund will probably have a cheaper expense ratio.
The one advantage of an ETF is if you already have a brokerage account and don’t want to keep track of another account.
Bullshit. ETFs generally have lower expense ratios than traditional open-end index mutual funds since there are generally fewer administrative costs associated with running ETFs.
Another advantage of ETFs is that they generally have higher tax efficiencies than comparable index funds. Note that this only matters if you aren’t investing in a tax-deferred account.
A third advantage to ETFs is that they generally do not have as much cash drag as index funds because they don’t need to hold as much cash. Note that this would actually be a disadvantage for ETFs in a down market.
One problem for Mutual Funds is there are often initial contribution requirements that may be significant for a small time investor. For instance Vanguard Total Stock Market Index (VTSMX) has an initial contribution requirement of $3,000 ($100 additional contribution). If your plan is to contribute $100 a month, you’re probably going to be frustrated having to wait 2.5 years just to save up for your initial investment. The flip side, however, is that while you can buy a EFT for often as little as you’ve got, you’re going to pay a commission every time you buy any shares of the ETF.
One thing to note is that if you can hit the minimum investment of $10K, you can buy “admiral” shares for many (if not most) Vanguard index fund products. The admiral shares have the advantage of having half the expense ratio of the regular shares. (And Vanugard already has some of the lowest expense ratios in the business.) For example, VFIAX, Vanguards S&P500 index fund, has an expense ratio of 0.06%, which is lower than most ETFs.
If you plan to actively manage your positions by trading in and out of the investments, then index funds are the cheaper option. They don’t charge for activity, and only charge based on Assets under Management (AUM). With ETF’s, there is a bid-ask spread that could be significant when you’re buying and selling regularly. If you simply want to buy and hold, ETF’s are the way to go (in most cases).
Vanguard’s S&P 500 ETF (VOO) also has an expense ratio of 0.06% and the only minumum purchase required is one complete share, or about $62.
This is a very complex question. Say you’d invested in around 2003. You might have used an active ETF or fund where the manager saw the inverted yield curve and the bank sector taking a very large proportion of the total size of the S&P, and so he under-weighted banks.
A passive fund or ETF would’ve had to follow the S&P exactly, irregardless of whether one or more of the sectors was in a bubble.
The active manager would’ve earned his fees if he had significantly beat the index fund.
BUT, if he was a contrarian and decided banks were oversold, he might still have his new Porsche and your nest egg is no more.
I agree if you just want to track the index, then go for an ETF. Depending on how much you want to invest you could do this for the majority of the lump sum, then do some research and add a little sizzle (‘alpha’) to your returns. You also need to spend time if you take this option, so you need to factor in how much your time is worth.
It’s not a complex question at all. I think you misread it. The OP did not ask about active vs. passive investments. He or she asked about the difference between two passive options.
Yes, I agree it’s not a complex question and I over-engineered my answer. That’s a very fair comment and one I considered when typing. I wanted to let the OP know there were more options than just choosing between A and B. To me it’s like choosing between an entry-level Nissan and Toyota which both will give you unremarkable, safe and reliable motoring, when you could be choosing a used Audi A3.
Other considerations to be taken into account;
What age does the OP think they’ll be retiring at? What expenses will they still have to cover once they retire? Will all debts (they may have now) be paid off then? He/she may find their outgoings have come down drastically by the time they’ve stopped working full-time.
And will he/she still be able to work, albeit part-time, to increase income? If they can continue to do some part-time work this will greatly reduce the amount their pension pot needs to grow to. For example, if he/she can earn $50 per week, this is the same as having a pot of $65,000 - assuming they’d take 4% per year from it.
Also what are they doing to pay down debts now, and can they do any more?
Along that line of thought; what are they doing to decrease their expenses now? For example, when was the last time he/she checked to see if they have a good deal on their car insurance? etc etc
Finally, does their work provide a pension scheme? If so this is the best place to look first.
I’m no longer a financial advisor, so I can’t comment on current tax issues - they’d be best off seeking council from a professional for their needs.
Important caveat: Vanguard, the index leader and largest mutual fund co in the US, is organized as a cooperative. So their index funds -whether ETF or open ended mutual- typically have lower expense ratios than iShares et al, with a few exceptions. (Some groups offer lower expense ratios for their SP500 fund, probably as loss-leaders.)
Ok, but Vanguard’s SP500 and Total Stock Market has been highly tax efficient. Their Tax Managed Growth and Income fund has had equal tax efficiency as their SP500 fund over the past decade, but with a slightly higher expense ratio. 
Interesting. I had not thought about this one.
Re: the OP. Evaluate this fund by fund. Don’t just assume that all ETFs will be the same. And get thee to Vanguard.
(This is not investment advice. I have never had an employment relationship with Vanguard and as noted above they float no shares on the stock market.)
I should also point out some of the exceptions to the rules.
When I first started buying Vanguard funds I do not believe there was **any **way to buy into the fund without meeting the minimum investment ($3,000) to buy into the fund, after that you could add to your ownership in the fund with a small monthly contribution.
The only way I believe you could easily get around that is some corporations or other employers had 401(k) plans in which you could allocate pretax dollars to a Vanguard fund without having to do that large up front purchase.
At the same time, the problem with ETFs has been if you want to buy ETFs regularly (say as often as you get paid) you had to pay commission on each trade.
A lot of people want to invest a certain percentage every pay check, because most people find it far easier to invest for retirement if that money is either taken out as a payroll deduction or set up in some other way so that the person doesn’t have to “decide” how it is used (i.e. through auto withdrawals from your bank account.) When you first start saving for retirement in a personal investment account (as opposed to employer plans which are much easier to get started with) you traditionally then had the conundrum of wanting to invest a portion of your pay check each week but not having enough upfront money to buy into a fund which would allow you to do that. The alternative, ETFs, charged commissions which make small periodic purchases unwise.
Luckily the market has responded in two ways:
Many funds now allow you to buy in without having to pay the $3,000 minimum. You can now get into many mutual funds by signing up for a $100/mo auto contribution and there is no up front buy in required.
Many online brokerages have introduced 100% commission free ETF trading. I believe E*Trade and Ameritrade in particular now have commission free ETF trading, I believe Scottrade continues to charge commissions for ETF trading. The only limitation is I believe there is only a certain basket of specific ETFs which are commission free.
With Vanguard specifically I believe the last time I looked if you opened an IRA with them you could buy into their mutual funds without the $3,000 minimum buy, so that’s probably worth considering.
Vanguard has commission free ETF trading for its own ETFs. Schwab has a similar deal.
Schwab has low expense ratios on some of their ETFs, though the investor might reasonably wonder how long they will stay that way.
This thread has gotten me really thinking about things. Anybody have an IRA account with Vanguard? Right now I’m with Buy and Hold. No issues at all, except even a dirt cheap $3 commission is still eating you alive if you can only afford $100-$150 a month. 75% of my Roth is in Vanguard Total Stock Market ETF anyway.
Another question to ask is how vulnerable you are if the institution running the ETF or mutual fund goes bankrupt.
The underlying assets in the ETFs I own are held in trust specifically for the owners of the fund. That means that if the institution running the fund goes bankrupt, it’s not a complete disaster for me and the other owners - the assets would be sold on the market and then then the assets distributed to the owners. I don’t know if this is the way ETFs must be structures or whether only some are.
Conversely, a lot of mutual funds aren’t structured like that. So the bank or whatever holds the assets and says the investor owns a certain percentage of the fund, but if the bank or whatever goes bankrupt, then the assets in the fund are considered fair game to all creditors to the bank and the owners of the mutual fund don’t have any special claim to them.
Note - this is a separate issue from whether the stocks held by the ETF or mutual fund go bankrupt. You’re vulnerable to that either way.
Another thing I just heard…a lot of funds are coming out with Target Date ETFs. However, a lot of these funds hold nothing but other funds the company holds. So ACME Target Date 2030 ETF, might hold ACME S&P Growth, ACME EAFE Index, etc. The problem is, this could be a way for companies to essentially double dip as far as Expense Ratios are concerned. So you’d be paying the expense ratio for your ETF AND every other ETF it holds.
JustinC, the question was indeed kept to a limited focus specifically to avoid the longstanding debates between attempting to track an index versus trying to beat it. Nor was the op intended to elicit thoughts on broader issues of financial planning. I thought it might get complex enough trying to get me to understand how ETFs and mutual funds each must handle dividends and other income in different ways. I don’t quite get that even though I know they do. For the purpose of the question just consider that the investor in question is considering having some portion of their investments in an index vehicle or two. Given that does an index fund vs an ETF that attempts to track the same index make more sense? Does it matter if the index is one designed to follow high dividend stocks? Does it matter if the index is one that tracks income producing investments? Should it be based exclusively on choosing the lowest fees?
I’ll expand to another area of my ignorance - REITs. Assume investing in either a REIT ETF or fund and assume an investor who is at the top marginal tax rate. Assume this investor has monies that they are investing within an IRA vehicle and monies outside one.
How is money produced by a REIT handled in terms of tax consequences and for that investor out of which bucket does it make more sense to hold a REIT if they decide to have some diversification into that sort of investment?
What place REITs in today’s investment universe?
As far as my needs - I am content with the distribution of my retirement funds and they are on track. Some in a spread of funds (and I have gone more active than index funds there) and some self managed (but with a long term hold philosophy to any purchase) and beating the indices over time. Still as I get a bit older it is time to move into a more conservative position, and eventually, over the next 15 to 20 years, into some greater share of income producing investments. Meanwhile the college funds took a big hit as child two of four went off to school just as the market collapsed and the 529’s and other funds put away for college dived. Two more kids to go and his needs used up a bigger chunk than was planned of what was in those vehicles those first two years; less was left in to recover with the market. And in that context a moderate windfall occurs (inheritance). Some will go into the other kids 529s (to start college in 3 and 9 years respectively) and some will be used to fund the remaining two years of college for child two.
So let’s focus on the monies that are to be used over the next two years. And let’s assume an investor who does not want to keep too big of a cash position …