When ETFs Are Better Than Index Funds

Investors are voting with their dollars, favoring exchange-traded index funds over index mutual funds. I think they're making a mistake.

The best strategy is to own both. Use index mutual funds for accounts you're regularly adding to or drawing on, while stashing longer-term money in exchange-traded index funds. That combo should trim your investment costs - and further boost your fund returns.

Stock-index mutual funds, which you can purchase directly from the parent fund company, still have 39 percent more assets than ETFs, which you have to buy through a full-service or discount broker.

But growth rates tell another story. Since year-end 2002, assets in index mutual funds have climbed 174 percent, but much of this increase can be explained by market appreciation. By contrast, ETF assets have soared 431 percent, as investors overwhelmingly favor these funds with new investment dollars.

To be sure, ETFs offer advantages. They often have lower annual expenses than comparable mutual funds. They should be more tax-efficient. There's variety, with ETFs that track indexes both well-known and obscure. And because they are listed on the stock market, you can trade them throughout the day.

Indeed, ETFs are a favorite of traders and those aiming to make focused investment bets. Got a thing for Swedish stocks? There's an ETF for you.

On the other hand, if you're looking to sock away money regularly in a diversified index-fund portfolio, ETFs often don't make sense. With every trade, you pay a brokerage commission and lose a little to the bid-ask spread, the slight difference between an ETF's selling share price and its higher purchase price. Those trading costs mean ETFs usually aren't economical for anyone putting away $100 or $300 at a time.

Splitting Up

Suppose, however, that after regularly salting away that $100 or $300, your index mutual fund accounts are worth $20,000.

One possibility: Move a chunk of that money into ETFs to take advantage of their lower expenses. Meanwhile, for monthly savings, continue to use index mutual funds so you don't rack up trading costs. Similarly, if you are retired and drawing down your accounts, keep money you will need soon in index mutual funds, and stash long-term savings in ETFs.

Say you own a mutual fund such as Vanguard REIT Index, a real-estate fund that charges 0.21 percent of assets in annual expenses. You could reduce expenses to 0.12 percent by swapping into Vanguard REIT ETF. A good move? If you use a discount broker, you should come out ahead with the ETF if you invest $10,000 and sit tight four or five years.

Dodging Potholes

All this comes with three caveats: First, consider taxes. Moving into an ETF won't have any tax bite if you trade within a retirement account. But if you hold index mutual funds in a taxable account, the swap could trigger capital-gains taxes.

Second, some index mutual funds charge a $10 or $20 annual account fee if your balance is below $10,000. To avoid that fee, keep a minimum of $10,000 in each index mutual fund.

Third, don't assume ETFs will always be cheaper, even if you have a long time horizon and a big chunk to invest.

For instance, in 2004, Fidelity Investments slashed expenses to 0.1 percent on four stock-index mutual funds geared toward ordinary investors. These four funds, which have $10,000 minimums, track major indexes such as the Standard & Poor's 500 and the Dow Jones Wilshire 5000.

There are ETFs that have annual expenses slightly below Fidelity's 0.1 percent. But the cost savings is so tiny it would be tough to beat the Fidelity index funds, once you figure ETF trading costs.