A market index reflects the average performance of a group of similar investments over a given period of time. The best-known example is probably the Standard & Poor’s 500 Index (the S&P), which tracks the stocks of 500 big companies that represent 70% of the value of the U.S. stock market. But there are many others. Among them:
• The Wilshire 5000 Index tracks all U.S.-based companies traded on the New York, American, and Nasdaq stock exchanges.
• The Morgan Stanley Capital International Europe, Australasia and Far East Index— known as the MSCI EAFE—is a composite of 1,000 foreign stocks in 21 countries outside North America.
• Barclay’s Aggregate Bond Index mirrors the performance of more than 5,000 U.S. government and corporate bonds.
An index mutual fund mimics a market index. The fund simply buys and holds the stocks or bonds that make up the market index it’s following. Index funds have lower expenses than other mutual funds because they don’t have the same research, portfolio management or trading costs.
You buy fund shares from the fund manager. The price you pay is based on the market value of the stocks and/or bonds the fund holds at the end of each trading day.
An ETF is an index fund that trades all day, like a stock. An index fund, by contrast, trades only once, at the end of the day.
You buy and sell ETF shares from other investors, through a stock broker, instead of from the fund manager. The price of ETF shares is determined by supply and demand, so at any given time you may pay more—or less—than the fund’s current market value.
Index funds typically require a minimum initial investment of at least $2,000. There’s no required minimum for ETF investments. You can invest as little as the price of one share.
• ETFs have one major cost advantage over index funds: They give you greater control over your tax bill. You won’t incur any tax on your profit until you sell your shares. With an index fund (assuming you hold it in a taxable account) you’re taxed on your share of the fund’s profits every year, even if you haven’t sold any shares and have reinvested all your dividends.
• ETFs also have one major cost disadvantage:
You must pay a brokerage commission every time you buy or sell shares. By contrast, you can buy and sell traditional mutual fund shares without incurring a brokerage fee.
• Consider an ETF if:
— You’re making a single investment and won’t incur repeated brokerage fees. Online brokerage commissions can be as high as $20 per trade, depending on the broker. This cost can add up quickly if you’re buying shares every month.
— You don’t have the $2,000 to $3,000 minimum initial investment typically required by traditional index funds.
— You want to use sophisticated investment techniques like options or short selling. You can’t use these techniques with conventional mutual fund shares.
• Consider an index fund if:
— You plan to make periodic contributions or redemptions.
— You want your share price always to reflect the current value of the fund’s underlying assets, rather than investor demand for fund shares.
— You won’t use techniques like short selling or buying options on your shares.
Index funds and ETFs both offer sensible, inexpensive ways to invest in a broad market. You may have room for both in your portfolio. For example, you might choose an ETF for a lump-sum inheritance that’s going into a taxable account but prefer to make periodic contributions to an index fund in a tax-deferred retirement account.