Playing The Market: Index Funds Or ETFs?

Index funds and exchange traded funds both track indexes, which one is right for you?

To get to your answer, let’s take a look at how each fund operates, how you can buy shares and what you will have to pay for.

Photo by red nuht, courtesy of flickr

ETFs operate as closed-end funds. There is a set number of shares, so if you are able to buy shares, those shares will come from another investor who is selling them.

How to buy shares – Shares of an index fund can only be purchased at the end of each day.

After the market’s close, the value of each asset in the portfolio is determined and used to calculate the fund’s net asset value (NAV). The NAV is the fund’s price per share. You can purchase shares directly from the fund or you can use the services of a broker.

ETFs trade like shares of stock, so you can purchase them throughout the day and trade them on margin. Because they are traded in the secondary market you have to use a broker.

What you will have to pay – Index funds can come with loads and expenses. A load is a one-time sales charge that can be assessed on the front end (when you buy shares) or the back end (when you sell shares). Expenses are recurring items (i.e. management, marketing, reporting fees) which must be covered each period.

ETFs do not have loads, but you will have to pay commission to your broker to buy or sell shares. Some ETFs have operating expenses, but they are typically much lower than their index fund counterparts.

Which should you invest in? Since both funds will holdings the same portfolio as the underlying index, I would use your investment horizon as the initial decision maker.

If you are in it for the long haul, then depending on its costs, an index fund may be better. Index funds can carry loads or deferred sales charges which penalize you if you sell your shares before a specified holding period.

If you plan to be in and out, then you should probably use an ETF. Trading is more flexible and there is no penalty for selling quickly, just your broker’s commission.

The holdings of an index fund and an ETF that track the same index may look alike, but their operations, trading and costs can be very different.