INDEX FUNDS COME IN TWO FLAVORS. The pioneers were of the mutual fund variety. With a mutual fund, you can buy and sell just once a day, with the share price established as of the 4 pm ET market close. If you purchase no-load index funds, typically your only cost is the fund’s annual expenses.
The upstart competitors are exchange-traded index funds, or ETFs, which are listed on the stock market. You can trade them throughout the day, just like any other stock. ETFs have exploded in popularity over the past 15 years. They usually have lower annual expenses than comparable index mutual funds—but they ought to, because they don’t have the administrative costs associated with shareholders’ buying and redeeming shares. Instead, those costs are borne directly by the shareholders themselves. If you want in or out of an ETF, you have to go through a brokerage firm and trade the exchange-listed shares. That will mean paying the bid-ask spread, typically a brokerage commission and maybe also an annual brokerage-account maintenance fee.
Which are better, index mutual funds or ETFs? Many folks end up with ETFs because they’re looking to trade frequently in and out of the market, a costly strategy that can quickly wipe out indexing’s low-cost advantage. ETFs also come in more varieties, so they may be your only choice if you want a more specialized index fund, and you can buy them no matter which brokerage firm you use. In addition, ETFs have the potential to be more tax-efficient than index mutual funds, thanks to a peculiarity related to the way ETF shares are created.
ETFs will often be the better choice if you plan to invest a large sum and leave it there for many years. But that doesn’t describe the behavior of many ordinary investors, who might invest a modest sum initially and then add to their holdings frequently thereafter. If that describes you, you will likely find that index mutual funds make more sense, because you’ll avoid the trading costs involved with frequent ETF purchases.
Next: Picking Active Funds