An index fund is a mutual fund that owns all the stocks in a particular index. The index could be the S&P 500, the NASDAQ 1000, the MSCI EAFE, or any of a hundred other indexes. If you want your portfolio to have 80% domestic stocks and 20% international, then you could invest those proportions in two index funds. This would instantly give you diversification across hundreds of underlying stocks. Exchange traded funds (ETFs) are essentially the same thing, but they are considered slightly differently for tax purposes. They are considered baskets of stocks instead of many individual stocks. To me this is splitting hairs, but I’m sure it’s making investment companies buckets of money. Let’s see if an ETF does us common folk any good.

Let’s compare two scenarios: investing $10,000 in an ETF vs. and index fund.

(Warning: Plot Spoiler: A good index fund is as good as an ETF; however, not all index funds are made the same.)

Two good choices: The gold-standard S&P 500 index fund is Vanguard’s VFINX. It has no load and a low expense ratio of 0.15%. The biggest S&P 500 ETF is State Street’s SPY. It also has a low expense ratio (0.10%). An ETF trades like a stock, so there is a stock transaction fee for buying and/or selling shares of an ETF. For example, Schwab charges $12/transaction. If you’re buying $10,000 of SPY, you could consider the transaction fee a 0.12% load.

Two not-so-great choices: There are many funds that track the S&P 500. Here are two: one run by Allegiant and one by Munder: AEXAX and MUXAX. The first clue to a less-than-stellar report card is that these two funds only score two Morningstar stars, whereas a good index fund will have three. (Three stars means you are tracking the relevant index, and if it’s a good index fund, then you are tracking the index — not better and not worse.) Both of these have a front-load fee of 2.5%. Why anyone would pay a load for an index fund is beyond me, but if you have a financial adviser who is paid through loads, he’ll sell you this fund and not the Vanguard fund. Both of these funds have significantly higher expense ratios: 0.62% for AEXAX and 0.60% for MUXAX.

Managing an index fund: The beauty of an index fund is that you don’t have to pick the winners — you just have to hold whatever stocks are in the index. As a manager of an index fund, your job is then focused on maintaining liquidity — buying or selling enough to invest new money coming into the fund and to be able to handle redemptions. If you don’t handle this inflow and outflow well, then you have to buy and sell frequently, driving up expenses.

Capital gains: When a fund sells stocks, it may have to realize capital gains. Mutual funds are required to pass on realized capital gains to shareholders at the end of the year, and the shareholders have to pay income tax on it. ETF’s do not have to realize gains, since all their transactions are considered wash sales (the simultaneous buying and selling of the same stock). Don’t ask me why they are treated differently. I wouldn’t be surprised if this tax loophole is closed sometime — not in the near future, but perhaps before your retirement. So another sign of a bad index fund is if they’ve distributed capital gains — this means they’re not handling their cash flow well.

Dividends: Even well-managed funds and ETF’s have to distribute dividends. When one of the stocks declares a dividend, it gets passed on to the shareholder. You really can’t get around this. However, our two “bad” funds, AEXAX and MUXAX, distributed twice as much in dividends as did the good choices. I have no explanation for this, unless they somehow bought extra shares just before the stocks declared a dividend — but that doesn’t make sense if they’re tracking an index. Whatever the reason, you’ll pay more in taxes, if they distribute a lot in dividends.

Here’s the data in a table:

SPY VFINX AEXAX MUXAX
Dividends paid 2004-2008 $11.07 $11.42 $1.69 $5.21
Capital gains paid 2004-2008 $0.00 $0.00 $1.01 $1.36
Share Price 1/1/2009 $89.60 $82.51 $7.16 $16.29
Avg. Ann. Div & Cap Gains (%) 2.47% 2.77% 7.53% 8.07%
Expense ratio (per year) 0.10% 0.15% 0.62% 0.60%
Front Load 0.12%* 0 2.50% 2.50%

The first two lines are the total dividends and capital gains paid to shareholders in 2004 through 2008. The fourth line is the sum of the dividends and capital gains as a percentage of the share price. This is a measure of the funds’ tax efficiency. Note that you will pay three times as much tax if you hold either AEXAX or MUXAX instead of VFINX or SPY. Yikes! That’s on top of the 2.5% load and the 4-5x higher annual expense ratios. Double yikes! And these funds get two Morningstar stars? Whaddyagottado to rate only one?!

In sum, I’d say that a well-managed index fund is as good as an ETF; but not all index funds are created equal. Watch out for the expenses. There are probably bad ETF’s out there, too, but we’ll look at that another day.

Here are some other references on ETFs: Investopedia, Motley Fool, and Queercents.