ETF vs. Index Fund: Which Is Best for You?

By Markets Fool.com

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The difference between an ETF an index fund is not as insignificant as it might seem. It isn't just about performance, or which type had the best returns. Making the wrong choice could cost you thousands of dollars in extra fees and commissions and require hours of work on your part.

The differences boil down to four main pillars -- fees, minimums, taxes, and liquidity -- all of which ultimately determine whether your best option is to buy an ETF or stick to an index fund.

1. Fees and expenses

ETFs generally have a slight advantage when it comes to annual expense ratios. Vanguard, a leader in index funds and ETFs, frequently charges its typical investor higher fees on mutual funds than it does ETFs.

Vanguard's S&P 500 ETF (NYSEMKT: VOO) carries an annual expense ratio of just 0.05% of assets. The exact same fund in an index mutual fund wrapper -- Vanguard 500 Investor Shares (NASDAQMUTFUND: VFINX) -- has an expense ratio of 0.16%, more than three times higher than the ETF alternative. The gap in fees closes for investors who qualify for Vanguard's Admiral share class of index funds.

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Expense ratios aren't the only expenses that matter, however. Because ETFs are bought and sold like stocks, you will pay a commission to a broker to buy and sell, thus negating the advantage of lower expense ratios.

Dividend distributions compound the issue of the differences in how ETFs and mutual funds are bought and sold. Index fund dividends are typically automatically reinvested commission-free into more index fund shares. However, when an ETF pays a dividend, you'll need to use the proceeds to buy more shares, incurring additional commissions and wasted time logging in to your account to make a quick trade.

2. Minimum investments

You can invest in an ETF by buying as little as one share, making the initial minimum for ETFs much lower than for index funds. However, despite higher initial minimum investments, index funds typically have much lower minimums for add-on investments.The following table shows the minimum investments for S&P 500 index mutual funds from three leading asset managers.

Fund Manager

Initial Minimum

Minimum Additional Investment

Fidelity

$2,500

no minimum

Vanguard

$3,000

$1

Charles Schwab

$100

$1

Data source: Company websites.

Unlike ETFs, index mutual funds can be purchased in partial shares. After satisfying the $100 minimum investment in Charles Schwab's index funds, for example, you'll be able to make add-on investments as small as $1, even though shares of its S&P 500 index fund were valued at just over $34.16 at the time of writing.

3. Tax differences

Long-term investors who are saving for retirement should use tax-advantaged retirement plans such as 401(k) plans and IRAs. I say this not just because it's smart -- minimizing taxes is a good thing -- but also because it means you can completely ignore complicated, boring dissertations on the tax consequences of investing in mutual funds vs. ETFs. If you're investing in a retirement account, you can skip this section altogether -- it doesn't apply to you.

All else equal, index funds and ETFs are extremely tax efficient, certainly more tax efficient than actively managed mutual funds. Because index funds buy and sell stocks so infrequently, they rarely trigger capital gains taxes for their owners.

But when it comes to the tax efficiency of ETFs versus index funds, ETFs are king. The simple reason is that ETFs rarely buy or sell stock for cash. When an investor wants to redeem his or her investment, that person simply sells shares of the ETF on the open market.

When an index fund investor wants to redeem his or her investment, the index fund has to sell stocks for cash to pay the investor for the shares. This can frequently result in the realization of capital gains, which result in taxes for everyone who continues to hold the fund -- even if those people are currently losing money on their investment in the fund as a whole.

Remember, capital gains taxes are the only truly voluntary tax. If a fund never sells an investment that has risen in value, and its investors never sell the fund, no one will owe any capital gains taxes on the unrealized gain.

4. Liquidity

Liquidity, or the ease at which an investment can be bought or sold for cash, is an important differentiator between ETFs and index funds. As previously mentioned, ETFs can be bought and sold like stocks, meaning you can buy or sell them at any time the stock market is open, whether that'swhen the market opens at 9:30 a.m. Eastern time, or on your early-afternoon trip to the office water cooler.

Mutual fund transactions are cleared in bulk after the market has closed. Thus, if you put in an order to sell shares of an index mutual fund at noon, the transaction will actually take place hours later at a price equal to the value of the fund at market closing time. Typically, the cutoff time is 4 p.m. Eastern time. Orders that are entered after the cutoff are pushed into the next day and completed at the price a day later.

If you're a trader, this matters. If you're an investor, it really doesn't matter much at all.

Should you buy an ETF or index fund?

Though I'd advise against trading the short-term fluctuations of the market, traders should naturally stick to ETFs. Investors who are saving amounts beyond the limitations of tax-advantaged retirement accounts should schedule a date with a local accountant who is versed in local, state, and federal taxation. At that point you are, or will soon be, at a level of wealth that brings about far more important tax considerations than the modest differences in after-tax returns between an ETF or index fund.

But if you're investing for the long haul through a tax-advantaged account such as a 401(k) or IRA, expenses and convenience are the main points of consideration. Barring some ridiculous pricing difference between an ETF and a similar index fund (say, an expense ratio of 0.05% for an ETF and 1.20% for an index fund with some particularly onerous fees attached), your best bet is the index mutual fund.

The advantage of commission-free purchases, low minimums for add-on investments, and the ability to automatically reinvest a fund's distributions back into new shares make index mutual funds a much better choice than ETFs for the average buy-and-hold investor.

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Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.