24 Aug Exchange-traded funds vs. index funds

Q. I have Vanguard mutual funds. Is it better to have an exchange-traded fund (ETF) or index fund?
— Investor

A. Without knowing more about your personal finances, we can’t answer specifically.

Every investor is different, so there is never one simple solution for any investment question.

But we’re going to assume you’re considering either an ETF or index fund that both have the same benchmark. Let’s compare the two.

One main difference between an ETF and an index mutual fund is that the ETF trades continuously while the market is open. That compares to an index mutual fund, which trades one time a day at market close, said Anthony Benante, a chartered financial analyst with Baron Financial Group in Fair Lawn.

There are other factors to consider.

“In general, active investors may prefer the trading flexibility offered from ETFs, while long-term buy-and-hold investors may prefer using a straight index mutual fund to gain exposure to a specific benchmark,” Benante said.

Benante said you should also look at the costs.

He said some ETFs can have transaction costs, however, some brokerages allow for free trading for certain ETFs.

For index mutual funds, you may be able to go direct to a mutual fund company and invest with no transaction cost, but you could pay transaction charges in a brokerage account for that same fund, depending on where the account is held, Benante said.

There are other factors that can also impact costs and ultimately, the return.

“For ETFs you should be aware of the spread between the bid and the ask price,” Benante said. “The larger the spread, the higher the implied cost is for investing in the ETF which may possibly cause the overall return realized to be lower versus the benchmark.”

Also, he said, an investor needs to understand the strength and depth of the ETF to make sure there is ample liquidity during volatile markets.

He said investors can research the daily volume traded, the overall size of the ETF and other factors to better understand the strength of the ETF.

Also know that index mutual funds may be required to hold a portion of the fund in cash to meet investor redemptions, which could contribute to lower relative performance when the benchmark’s performance is positive, he said.

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This post was originally published in August 2017.