Thursday, October 7, 2010

ETFs vs. Index Funds: Expenses Matter

The Wall Street Journal recently had an article extolling the virtues of exchange traded funds (ETFs). Basically, ETFs are baskets of stocks that trade openly on an exchange. Most of them are like index funds in that the ETF tracks a specific index by holding the stocks in the benchmark index in proportion to their weight in it. For example, the Vanguard Total Stock Market Index (VTSMX) has an ETF counterpart, the Vanguard Total Stock Market ETF (VTI) which trades all day just like a stock. This can be a good or bad thing. When you send money in to buy a mutual fund, your trade is typically processed at the price at the end of the business day in which your money is received. The constant price changes in an ETF make it appeal to traders who may play the continuous price movements by buying and selling constantly.

However, as a rule, the one time I will recommend an ETF over its index fund counterpart is when the ETF has lower expenses associated with it. For example, the article mentions how "the average ETF expense ratio is 0.6% of assets, compared with an average 0.8% for traditional index funds, according to investment researcher Morningstar." This amount will differ on a firm by firm basis, but the lower the expense ratio, the better. However, make sure that you're not incurring any type of substantial commission by buying the ETF - after all, purchasing an index fund through a firm like Vanguard is free - you will simply incur year end expenses deducted from your fund's assets.

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