Should You Switch to an ETF From a Traditional Index Fund?

Question: Although I've long held index funds in my portfolio, lately I've been wondering whether I'd be better off in an exchange-traded fund with a lower expense ratio. I seem to hear about a new lower-cost ETF almost every day, and many firms are waiving commissions.

Answer: You're right--the advent of commission-free trades has removed what has heretofore been one of the chief drawbacks of investing in ETFs relative to traditional mutual funds, particularly for dollar-cost averagers. But that's not to say your decision about whether to invest in an ETF or index fund should begin and end with the cost analysis. As you evaluate whether you should give your traditional mutual fund the heave-ho, here are some of the key questions to consider.

How do the costs compare?
Although there are certainly exceptions, most broad-market index-tracking investments are commodities, meaning that costs are one of the main, if not the only, differentiators. At first blush, it may not seem like a big deal if a traditional index fund costs 0.15% and an ETF charges 0.06%, but over time that 0.09% expense differential can result in a meaningful return difference. Use Morningstar's  Cost Analyzer tool to see how much you could save if you were to swap your index fund for a lower-cost ETF; the tool factors in both expense ratios as well as any commissions you'd need to pay to buy or sell your shares. Some ETF purveyors have calculators that can determine the impact of bid-ask spreads along with transaction costs and expense ratios, such as this one from Vanguard.

Do you have a capital gain or loss in your traditional fund?
If it looks like you'll save money by switching from an index fund to an ETF, don't stop there. Also consider the tax consequences of selling if you hold the investment in a taxable account. (You can skip this step if you hold the investment in an IRA.) If the index fund's net asset value is currently higher than your cost basis, you'll owe capital gains tax when you sell, and you may not save enough over the life of your ETF investment to make up for the tax hit. Morningstar's  Trade Analyzer tool helps you factor in the tax costs of making the switch.

If your index fund is trading below what you paid for it, you could sell, book the tax loss, and swap into a similar ETF. Just be careful not to trigger the wash-sale rule. That means that for your tax loss to be allowable, you'd need to either wait 30 days after selling out of the index fund to buy an ETF that tracks the same index, or buy an ETF that tracks a different index.

Does the ETF trade in line with its market price?
With traditional index funds, the prices of all of the securities in the portfolio are aggregated at the end of each day, so the fund's NAV simply reflects that value, divided by the number of shares of the fund.

An ETF's NAV is calculated in the same way. But ETFs also have a market price, which is the value that investors are willing to pay for each share of the ETF at any given minute during the trading day. In the case of widely traded ETFs, market prices are right in line with NAVs. But during times of volatility, there have been occasions where ETF market prices have diverged from their NAVs, in some cases significantly.

The Monthly Premium/Discount % section, at the bottom of the Performance tab on Morningstar's ETF reports (click here for an example), enables you to check whether an ETF has a history of trading at a premium or discount to its NAV. That's not a deal-breaker and could in fact mean that the ETF market price is more current than the NAV, as Morningstar ETF analysts Paul Justice and Bradley Kay discuss in this 2010 video. But it's a phenomenon with which you should be familiar before jumping into ETFs with both feet.

Is tax efficiency a big consideration?
One of the chief benefits of both ETFs and traditional index funds that track broad stock market benchmarks is that they're apt to be more tax-efficient (that is, they pass on fewer taxable capital gains to their shareholders) than actively managed mutual funds, whose higher turnover rates can mean higher tax bills. (Bond ETFs aren't likely to be any more tax-efficient than bond index mutual funds.) So either an ETF or an index mutual fund is a good bet for the stock portion of your taxable portfolio. But ETFs can pull additional levers to keep tax efficiency down, as discussed in this slide show. Although ETFs haven't always been more tax-efficient than comparable traditional index mutual funds, over time ETFs have more tools on hand to keep the tax collector at bay than do traditional index funds.

Do you use options? Do you trade intra-day?
Setting aside the question of whether these techniques are advisable for most individual investors (and I'd argue that they're not), it's worth noting that ETFs offer a greater range of trading tactics, including the use of options and intra-day trading, than are available for investors in traditional index mutual funds. If you value that flexibility--and more importantly, if you have reason to believe that you can profit from it--then switching to an ETF may make sense for you.

Are you starting small?
ETFs don't have minimums, unlike traditional index mutual funds, making them a good choice for investors who like indexing but don't have a lot of money to get started. However, if you expect to have a low balance in your account, keep an eye out for account-maintenance and other fees, which can take a big bite out of smaller investment amounts.

A version of this article originally ran on June 29, 2010.

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