The Motley Fool has long been a proponent of index investing. After all, who can argue with superior results and lower costs?
As simple (and sound) as that advice may be, implementing it can become complicated. There are a lot of mechanisms for investing in indexes these days. First, you have traditional index mutual funds -- hundreds of them. And then you have exchange-traded funds (ETFs). Spiders (AMEX:SPY), which track the S&P 500, Qubes (AMEX:QQQ), which track the Nasdaq 100, and Diamonds (AMEX:DIA), which track the 30 stocks in the Dow, are just the tip of the iceberg. Take a look at the American Stock Exchange website for exchange-traded funds to get some idea of how complex this mutual fund alternative has become.
Generally, ETFs have lower fees. And because they are basically just a batch of the stocks in the index they match, they do track their underlying indexes very closely. But that doesn't necessarily make them a better choice than an index fund. It depends on how you invest. If you are big spender -- putting thousands of bucks into a single investment at a time -- ETFs are the better bet. However, if you are more the slow-and-steady type -- investing a few bucks every month -- an index fund would be more efficient.
It comes down to that old investor's bugaboo: commissions. ETFs are traded exactly like shares of stock, which is great. You can easily get a quote on them at any time, and you can buy and sell them through any broker. But even the cheapest discount brokers will change you in the neighborhood of $8 per transaction. If you are putting away $200 at a time, that's a 4% commission. Why handicap your investment when a free alternative exists? There are several no-load (i.e., no-commission) index funds with low expenses that won't charge you a thing to invest. (There are index funds with high expense ratios and even some with loads. Just pretend they don't exist.)
It's true that, eventually, the lower expense ratio of ETFs will overcome the effect of paying a commission to buy them, but for small amounts, "eventually" could amount to several decades. By the way, when I say "higher" expense ratio, let's keep in mind that the Vanguard 500 Index fund has an expense ratio of less than one-fifth of one percent (0.18% to be exact) while Spiders, which also track the S&P 500, have an expense ratio of 0.12%, and the even cheaper iShares S&P 500 (AMEX:IVV) have an expense ratio of 0.09%.
So Vanguard would charge you $1.80 per $1,000 invested per year, while the iShare equivalent would cost you $0.90. At that rate it would take about nine years to break even on a $1,000 iShare investment, but a $10,000 investment would break even in the first year.
Considering that the average expense ratio for U.S. stock funds is around 1.5% and that most mutual funds underperform the indexes, all of these index options are bargains.
For more on choosing the right index investment for you, read our 60-Second Guide.
