ETFs versus index funds, which is better? Yesterday we determined what is an ETF?

In the overview, Jill mentioned that ETFs usually have lower expense ratios and are ideal for a one-time small investment that you will hold for a long time. They’re also good for trading a large group of assets at once. However, you have to account for the trading commissions both when you buy and adding money in the future.

That’s great… but just how do we actually figure out which one will have the lower cost in any given situation?

ETF and Index Fund Calculator

Luckily, Vanguard makes it really easy for us to compare the costs of an ETF or an index fund with their ETF calculator.

For example, I mentioned that I was moving a chunk of an old 401k to Vanguard this week. It’s $50,000 and I’d like to put some of it into the Vanguard Emerging Markets Index (VEIEX). Let’s compare it to the Vanguard Emerging Markets ETF (VWO).

The index has a 0.39% expense ratio and 0.25% purchase and redemption fees. The ETF has a 0.27% expense ratio and I would normally pay $7 per trade using Scottrade.

ETF and Index Fund Comparison

Compare a $50,000 investment over 20 years adding $5,000 per year, in the example outlined above, and the ETF is lower cost option, saving $5747. Here’s what the calculation looks like:

More ETF Factors

When you use the calculator, you’ll have to account for the following variables:

Free Trades. In the example, I used Scottrade. However, there are lower cost broker options like TradeKing and Zecco. Depending on which broker you are using, your results will vary.

Rebalancing Your Portfolio. One of the things that the calculator doesn’t take into account is the need to rebalance your portfolio. You’re going to have to determine how often you do this and the effect it will have on the expenses in your portfolio if you are using ETFs instead of index investing.

Admiral Shares. Once you have $100,000 in a Vanguard fund, you get admiral shares with lower expenses. You’ll have to compare the admiral shares to the ETF too, to make sure you’re still getting the lowest cost.

In the example with the emerging markets index, even if you compare the admiral share class (VEMAX), which has a lower expense ratio of 0.27%, the ETF still is the lower cost option, in large part to the purchase and redemption fees.

However, when you look at the total stock market, like when I started a young family member in a Vanguard ETF for her Roth IRA, the ETF is lower cost for the same example above, but the Total Stock Market Index Fund Admiral Shares (VTSAX) is the lower cost option using the admiral shares. This is mainly due to the difference in expense ratios. The total stock market index fund (VTSMX) has an expense ratio of 0.18% compared to the ETF (VTI) at 0.09% and the Vanguard Admiral Share class at 0.09%.

Action Plan

Right now, I’m still using index funds for the majority of our portfolio. However, after doing some research with the emerging markets ETF, I’m considering using the ETF for a portion of our portfolio going forward.

Do you use index funds, ETFs, or a combination of both in your portfolio?

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Whether you are investing through tax-advantaged retirement accounts or in other taxable accounts, you might want to consider Exchange Traded Funds, or ETFs, as part of your long-term investment strategy. ETFs are one of several ways to invest in equities. Others include individual stocks, mutual funds, or index funds.

What is an ETF?

An ETF is simply a fund made up of multiple securities, somewhat like a mutual fund. ETFs differ from mutual funds in that they are continuously traded on the stock market (and thus revalued) throughout the day, making it easy to buy or sell at any time.

ETFs can be made up of securities that track a stock index (like the S&P 500) or instead choose to focus on a specific industry and/or country. ETFs are generally not actively managed – unlike a mutual fund the underlying stock investments remain the same from time to time. The price of an ETF is usually very close to the value of the underlying assets, but does not have to be.

ETFs also generate taxable income from dividends and charge a management fee just like a mutual or index fund.

Why choose ETFs?

ETFs are good for you if you have a one-time small investment, as they do not have a minimum investment. Be aware, though, that ETFs charge flat trading commissions that can be costly, so they will eat up a larger percentage of your initial investment the smaller that investment is. Long term, ETFs have lower expense ratios than mutual funds that can make up for the up-front cost. Since ETFs can be sold through a broker throughout the day, they allow investors to use techniques previously reserved for individual stocks such as buying on margin and short-selling.

ETFs are an ideal vehicle for trading a large group of assets at once. However, because of trading commissions, ETFs should be used by those planning to hold the same group of underlying assets for a long period of time. If you rebalance your portfolio often, or plan to purchase small amounts of shares regularly (such as through dollar-cost averaging), index or traditional mutual funds may be a better option for you than ETFs. Bottom line, ETFs are good options for those making a one-time new investment or for those looking to simplify and consolidate several small existing investments.

Getting started with ETF investing

Individual investors can buy and sell ETFs on stock exchanges through any broker, much like individual stocks. If you want to invest some of your retirement funds in ETFs, check with your current 401(k) plan administrator or IRA broker.

If you simply want to begin investing in an ETF outside of a retirement account, check with any major broker such as Fidelity, Vanguard, or Sharebuilder. Make sure to compare several funds to review past performance, dividend payments, and expense ratios. Look for Money Magazine’s recommended ETFs on their Money70 list – there are one or two ETFs in every category.

Further Reading

For more details about ETFs, and how they are created and valued, check out Yahoo!Finance, the Investment Company Institute Factbook, or About.com.

Check back tomorrow for ETFs versus index funds!

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Our investment club just finished reevaluating our broker. We do this every couple years to make sure we’re getting the best service and the best rates. We decided to stay with Scottrade.

Scottrade Account Details

• Account Minimum: None
• Opening Account Minimum: $500
• Account Fees: None
• Trading Fees: $7 per trade (market or limit), which includes stock and ETF trades*. Options have an additional $1.25 per contract. Mutual funds are free or $17 per trade depending on the fund.

Scottrade Details

Local Office. This comes in handy for an investment club, since we switch officers yearly. We still make all our trades online though.

Multiple Checks. Scottrade accepts deposits from multiple club members, something that many other brokers don’t allow. It becomes a hassle when you need to deposit checks at the bank and transfer the money monthly.

Integration with Software. We use Bivio for our club software, which is compatible with Scottrade to download our transactions. It makes the treasurer’s job much more manageable.

Cheap Trades. $7 trades work out well; it’s not the cheapest, but it is still inexpensive. We researched some of the low-cost brokers, but they didn’t offer all the services above, which are important for an investment club.

Individual and IRA Accounts. I also use Scottrade for some of my personal accounts and my family members, and my only complaint was when I ran into their silly fees to change my name.

Investment Clubs

I’ve been a member of our investment club since 2002. Here is more information about running an investment club:

• How to Start an Investment Club
• Investment Club Bylaws

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Zecco was on my short list in my search for a new brokerage, since they have dirt cheap, and sometimes free, trades.

I finally got around to checking them out last week after I heard about their April Fools’ Day joke. Apparently, when customers logged in last Wednesday, they were greeted with million dollar account balances. I love April Fools, so I had to check out any company that was willing to participate in such fun!

My Zecco Review

Zecco offers trades at $4.50 per trade, which is pretty cheap. It just barely edges out TradeKing at $4.95 per trade, and easily beats Scottrade (which is the broker I am trying to replace). You can also earn 10 free trades per month with a $25,000 account balance or if you make 25 total trades per month.

Account Details

• Account Minimum: None
• Opening Account Minimum: None
• Account Fees: None
• Trading Fees: $4.50 per trade, which includes stock and ETF trades. Options have an additional 50 cents per contract. Mutual funds are $10 per trade.

Zecco Details

Stock Screener. The stock screener was my favorite tool at Zecco. It was very helpful, since I could select multiple criteria that our investment club uses for evaluation. I will definitely be sharing that at our next club meeting, since we haven’t been able to locate a free tool that does something similar, so easily. Zecco also has about a dozen preset screens, if you don’t know what you are looking for.

Ticker. Normally, tickers at the bottom of the screen drive me crazy. However, I liked the Zecco ticker, because I could quickly put in my list of stocks to watch and see it scroll while I was working on some research.

Premium Tools. I was a little disappointed to see that you have to pay extra for Gainskeeper ($24.99 for six months). Although, you can try it out for free for two months. They also offer a Quotestream package with premium data analysis tools for $20 per month.

Free Trade Calculation. To get the free trades, you’ll need to reach the $25,000 minimum balance each month. As soon as your end-of-day balance hits it, your account will get the 10 free trades the next day to use in the remainder of the month. If your account goes below $25,000 your free trades will stay in your account.

Sign up for Paperless. They charge $2 per paper statement and $1.50 per paper trade confirmation, so be sure to sign up for the online statements, which are free.

IRA Accounts. They offer retirement accounts, but charge a $30 annual maintenance fee.

Forex Trading. If you are into forex trading, or want to learn more, they offer a $50,000 practice account so you can learn.

My Thoughts

The Zecco sign up was fast and easy. While it didn’t offer immediate approval, I got an email within the hour saying my account was ready to go. Once your account is set up, you can sign up for the free ACH service to fund your account.

The education section isn’t as robust as TradeKing, but then again, I wouldn’t necessarily look to my discount broker for learning how to invest in stocks.

They do offer cheap trades. If you are looking for a cheap broker, but don’t care about lots of extras, Zecco could be the way to go. I’m going to stick with them for awhile and see how they do beyond the initial account opening.

Even though they won’t meet my needs of finding a cheap broker to deposit old stock certificates (they charge $75 for stock certificate deposits), they are in the running for my new regular broker.

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The search continues for my new brokerage account. This week I opened a new account at TradeKing.

My TradeKing Review

I’ve written about TradeKing before, because they offered a great sign up bonus in the past. I didn’t get a chance to open an account then, but I figured now was a great time, since 2009 is all about execution for me!

Account Details

• Account Minimum: None
• Opening Account Minimum: None
• Account Fees: None
• Trading Fees: $4.95 per trade (market or limit), which includes stock and ETF trades. Options have an additional 65 cents per contract. Mutual funds are $14.95 per trade.

TradeKing Details

Their niche. TradeKing focuses on dirt cheap trades. At $4.95 per trade for market and limit orders, the price is tough to beat.

Research and Tools. The tools section is great. I started playing around with the various calculators and was impressed. Although to be honest, I haven’t ventured into the world of options in a long time, and I would have to dig out my old finance books from college to remember all the different terms! However, they do have an education center that could probably refresh my memory.

Dividend Reinvestment. For stocks that offer DRIP programs, you can enroll and dividends can purchase fractional shares.

Fund Availability. TradeKing offers stocks, ETF, bond, and mutual fund trading. I glanced at the list of mutual fund families and saw the majority of the big names listed.

Referral program. If you have friends that like to trade, you can refer them to get $50. Your friends must open the account with $1,000 and make a trade to get the referral bonus.

My Thoughts

TradeKing offers tons of information at your fingertips. They have great stock research tools, which could be very helpful for my investment club.

The application process took 5 minutes. Lots of questions about investing experience, but straightforward.

Funding the account wasn’t as efficient. If you opt for ACH transfer, the first transfer “takes at least 10 business days before you can begin trading.” After that there is a 5 day hold on ACH transfers. Other options are to mail a check, or do a wire transfer, but pay the fees.

Withdrawals must be done by either wire (for a fee), or you can request a check. It didn’t list ACH as a withdrawal option, but I contacted the live chat and verified you can use ACH for withdrawals too. Whew! However, you must wait 10 days from the deposit.

Although I’m on a search to deposit old stock certificates, TradeKing won’t be the broker for that. The stock certificate deposit processing fee is $100 per certificate. Yikes!

Overall, the interface looks really easy to use, and for the price, I think it could be a good replacement for my current broker. If only they had a more efficient way to fund the account when you open it. It sounds like it will be a week or two before I’m ready to place a trade.

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