Generally, index funds are mutual finds that try to replicate the movements of an index of a specific financial market.  For our purposes, we are most interested in index funds that reflect the market movement of different equity asset classes, such as large cap, mid cap, or small cap.

Some index funds are further characterized as growth, value, or blend within their market capitalization.  Index funds can include real estate investment trusts or REITs.  Different types of fixed income assets can be purchased through index funds, such as short term, intermediate term, or long term bonds.

ETFs are simply index funds that can be traded during the day on an exchange.  In comparison, orders to buy or sell index funds are executed at the end of the day.

Expense Ratios. Both index funds and ETFs offer diversification and low expense ratios.  For example, take a look at the Vanguard ETFs.  Expense ratios for their ETFs range from 0.13% to 0.30%, with expense ratios most of the index-based domestic stock ETFs 0.15% or less.  Vanguard also offers index funds covering a broad range of asset classes.  The expense ratios for index funds are  slightly higher than ETFs, but still far less than actively managed funds.

Expenses ratios for actively managed funds can range from 0.5% to 1.5% or more.  In addition, some actively managed funds have front end loads, back end loads, 12B6 fees, or hidden expenses built into in their transaction costs.  The worst of the actively managed funds, those with loads and high expenses ratios skim a huge amount of money from the unwary investor.  There is no correlation between fees/expenses and fund performance.

Performance. There is a large body of academic and statistical data that that shows that over a five-year period about 80% of the actively managed funds under perform the indices that correspond with the asset classes in the fund.  See, for example, the Standard & Poor’s Indices Versus Active (SPIVA)  scorecards.

Using ETFs or index funds to build a portfolio with different asset classes reduces risk and increases return.   Asset class diversification is the only “free lunch” in investing.  The low expenses ratios (as compared to actively managed funds) can make a significant difference over time.

ETFs vs. Index Funds. The primary disadvantage of ETFs is that you pay a brokerage fee each time you buy or sell them.  However, ETFs have slightly lower expense ratios.  As portfolio grows, eventually the savings from the lower expenses will offset any brokerage fees.  However, the most compelling reason for buying ETFs is that is easier for a small investor to build a diversified portfolio with multiple asset classes.  It doesn’t require a large amount of money.

Index funds generally require a minimum of $3,000 to open.  There is no minimum for ETFs, although you always have the brokerage see.  A $7 brokerage fee would be a 0.7% cost on a $1,000 purchase or sale.   There are more choices of asset classes with ETFs.

Tax Efficiency. ETFs and index funds are tax efficient because they do not time the market nor do they suffer from asset class drift.  They generally buy a sufficient number of stocks  to closely track an index that corresponds with their asset class.  They don’t buy or sale stocks except as necessary to track the index or cover redemptions and purchases.

Backtesting. There is a brilliant spreadsheet that is maintained by a participant in the Boglehead Forum.  This spreadsheet makes it possible to compare risk and return for a portfolio of various asset classes going back to 1972.  If you are considering building a portfolio of various asset classes using ETFs or index funds, this spreadsheet is an essential tool.

Resources. If you want to learn more about ETFs and index funds, and how to build a diversified portfolio, you should consider reading:

Paul Merriman’s website FundAdvice discusses passive investing at length and the use of index funds and ETFs to build a diversified portfolio.  The website has a large number of articles and some model portfolios.  There is also a link to their weekly podcasts.