Index Funds vs ETFS
August 27, 2018
So we’ve decided we want to beat over 90% of professional fund managers in the next 15 years and invest so that we don’t have to live off cat food in our 60s.
We trust Vanguard, the only mutually owned mutual fund company which provides index funds at cost by eliminating the profit motive.
Now that we’re ready to buy our first Vanguard investment, we have to decide… Do we want to use ETFs or index funds?
Definitions
Index funds - Funds that track an index such as the S&P500. These are extremely efficient investments as we covered in Why I Love Index Funds.
Investor Shares - e.g. Vanguard Total Stock Market Investor Shares (VTSMX) - Index funds where you would begin to invest when you have between $3,000 and $10,000. They have a slightly higher expense ratio than their equivalent admiral shares.
Admiral Shares - e.g. Vanguard Total Stock Market Admiral Shares (VTSAX) - Index funds where you would invest when you have over $10,000. They have the lowest expense ratios offered by Vanguard.
ETF shares - e.g. Vanguard Total Stock Market ETF (VTI) - Exchange Traded Funds generally have the same expense ratio as admiral shares. They are traded like stocks and have price fluctuations throughout the day like stocks.
Both the investor shares and admiral shares are referred to as mutual funds to differentiate them from ETFs or index funds to differentiate them from higher cost actively managed mutual funds. In this article, we will only be referring to Vanguard ETFs and mutual funds that track an index and not actively traded mutual funds.
Simplicity
When buying ETFs, the smallest unit we can buy is one share. On the other hand, we can buy any amount of index funds over a dollar. This makes it easy to rebalance and you can put every cent of your money market account (outside of your emergency fund) to work in these index funds.
In addition, index funds are priced once at the end of the day whereas ETF prices change throughout the day like other stocks on the stock market. The lack of change in index fund shares throughout the day discourages market timing which is a fool’s game anyways.
By buying the fund, you can also transfer to the ETF version of that fund at any time. Whereas if you buy ETFs, you cannot automatically transfer to index funds.
Advantage: Index fund
Minimum Contributions
Edit (2021): Now the minimum for the admiral shares is $3000.
The minimum contribution for Vanguard index funds such as the Vanguard Total Market Fund is $3,000. To get the minimal expense ratios we need to buy the admiral shares which have a minimum of $10,000.
On the other hand, the minimum investment for Vanguard ETFs are just the price of one share. In addition the expense ratio of the ETFs are equal to those of the respective admiral shares.
Advantage: ETFs while you have less than $10,000 per fund. However this difference is small in absolute dollars. For example, the total US stock market ETF would save us $11 per year over the investor shares per $10,000. By the time you reached $10,000 we could convert to admiral shares at the same expense ratio as the ETFs.
Capital Gains Taxes
In general, when other investors panic and sell mutual funds, fund managers sell some of the holdings of the fund and the remaining investors have to pay taxes on the capital gains realized by those sellers.
On the other hand, since ETFs are individual shares, only the person who sells his shares has to realize capital gains. However, Vanguard ETFs are structured as another share class of a mutual fund. This structure is protected by patent until 2023 which means no other mutual fund company can copy it until then. Because of this unique structure, capital gains are not realized when other investors sell their shares of the fund as long as the fund is also available as ETF shares. Thus, Vanguard mutual funds are just as tax efficient as ETFs. [1]
Advantage: Tie if using Vanguard
Fees
Edit (2021): The fees used to be the same at the time of publishing but now ETF fees are marginally lower than index fund fees. For example VTSAX has an expense ratio of 0.04% whereas VTI has an expense ratio of 0.03%. I still hold VTSAX for the convenience of having every one of my dollars at work and to avoid the bid ask spread.
As long as we are using Vanguard to buy and sell ETFs or mutual funds, there are no commissions on the buying or selling of shares. There is a $20 annual service fee for receiving your plan documents by mail but this is waived if you have over sign up for receiving these documents over email. [2]
Take into account that there is a bid-ask spread when you buy ETFs which is the difference between the lowest price asked for the ETF at the moment and the maximum bid.
Advantage: Vanguard
Results
Edit (2021): Now you can start directly with the lower cost admiral shares at $3000 instead of with the investor shares.
My advice is to start with the investor shares version of index funds for the flexibility and simplicity if you have between $3,000 and $10,000 to invest. When I started investing, I actually started with the ETF version of the total stock market index fund (VTI). About a year later, I had enough money to qualify for admiral shares. I sold those shares to convert them to the admiral shares so I could easily invest all the money in my account. The few days I spent out of the market cost me more money than the less than $11 savings from starting off with the ETF instead of investor shares. Thus, if I could give advice to my younger self, my advice would be to just start with the investor shares (VTSMX) and then convert to the admiral shares (VTSAX) later on.
If you already hold ETF shares and you want to convert to admiral shares because you’ve reached $10,000, just go ahead and do it without trying to time the market. In the grand scheme of the wild market ride, the fluctuation when we move our money from ETFs to mutual funds while we are at the beginning of our investing journey will not make a huge difference.