Free ETF trades make it really easy for small investors to put together a diversified portfolio at extremely low cost because the minimum investment in a ETF is just one share, usually less than $100. See previous post Low-Minimum Index Funds and Commission-Free ETFs for Small Investors.

If you don’t have a problem with meeting the minimum initial investment requirement and you are already investing in traditional open-end mutual funds, should you switch to ETFs?

You probably should, at least for the majority of your portfolio.

Lower cost is the biggest advantage of ETFs over open-end mutual funds. ETFs are primarily index funds. If you are investing in actively managed mutual funds, they usually cost several times more than the comparable ETFs and they don’t necessarily deliver superior results.

If you like index funds for their low cost, you will like ETFs even more since ETFs usually cost less than comparable index funds. Some index funds charge purchase and/or redemption fees; ETFs don’t.

Getting the same investment at lower cost means more money in your pocket. Vanguard offers a cost comparison calculator. I tried it with several ETFs. The ETFs won every time. Here’s an example:

For $30,000 invested in Vanguard Value Index Fund for 20 years at an estimated return of 6% a year, the total cost is $2,865. The total cost of investing in the equivalent ETF is $1,581, or 45% less. Who doesn’t want to save the cost of investing by 45%?

More choices is another reason for choosing ETFs. Vanguard has 29 index funds, but it has 46 ETFs. Schwab has five index funds and 11 ETFs. If you want something not available as an index fund, you may find it as an ETF. More choices means it will be easier to assemble a portfolio exactly the way you want.

ETFs and index funds are not mutually exclusive. Nobody says you can’t have both. Having both not only is OK but maybe even better than having only funds or only ETFs.

If you are not familiar with ETFs, you may be concerned about their trading aspects: the premium/discount to NAV, the bid/ask spread, market orders versus limited orders, etc. etc. If you are a Vanguard customer, don’t be afraid. You don’t have to master trading when you are investing in Vanguard index funds and ETFs. That’s another unique advantage to being a Vanguard customer.

Vanguard index funds offer a unique feature that lets you convert mutual fund shares into ETF shares at the net asset value. Not all Vanguard index funds have an ETF equivalent and not all funds offer conversion, but the majority do (20 out 29 index funds allow conversion to ETF, see list). You can convert the bulk of your index fund holdings to ETFs and still leave a minimum amount in the index funds for periodic purchases and rebalancing. When you accumulate enough index fund shares that make it worthwhile, you can convert them to ETF again.

Because converting from fund shares to ETF shares is done at the net asset value, you can be oblivious to the premium/discount, the bid/ask spread, or market order or limited order. If you have index funds in a taxable account, you don’t have to worry about triggering taxes either, because the conversion is a non-taxable event.

Isn’t it nice to have the best of both worlds? Mutual funds are easier to buy; ETFs are cheaper to hold. Have your cake and eat it too. If you are used to buying index funds every month on a set schedule, you don’t have to change your routine at all. Just convert the bulk of your existing holdings to ETFs and convert again maybe once a year after you do your rebalancing.

Is it too much trouble? I take it that most people have a checking account and a savings account or CDs. The idea is that you use your checking account for day-to-day spending and you use your savings account or CDs for more stable savings. You do that because the savings account or CDs pay more interest. Having both index funds and ETFs is along the same line: index funds for dollar cost averaging and ETFs for long term holdings. I think it’s not too much trouble and totally worth it.

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Software picked, likely related articles at The Finance Buff:

• Low-Minimum Index Funds and Commission-Free ETFs for Small Investors
• Buy Now Or Buy Gradually Over Time?
• Book Review: The Little Book of Common Sense Investing by John Bogle

Schwab has 5 index funds that require only $100 minimum initial investment. The lineup is not as extensive as Vanguard’s, but it’s adequate for a small investor. Although Schwab doesn’t have a bond index fund, customers can buy Treasury bonds at auction or buy new-issue CDs, all for free.

Schwab customers can also buy 8 Schwab ETFs without commission. Because these ETFs are new, my first choice would be the index funds unless the asset classes can’t be covered by the index funds. Here’s an example of a simple portfolio using Schwab index funds and ETFs:

It’s amazing to me one can invest ten grand for the cost of a few cups of coffee a year.

Fidelity has offered 8 Spartan index funds at low expenses for some time now. These index funds typically have a high minimum initial investment requirement, which makes them not feasible for small investors. In response to Schwab’s commission-free ETFs, Fidelity struck a deal with iShares to offer 25 iShares ETFs free of commission.

These iShares ETFs are among the most popular ETFs in the market. Although Vanguard ETFs have slightly lower expenses, for small investors, not having to pay a commission on small purchases is much more important than the expense ratios. Like Schwab, Fidelity also offers Treasury bonds at auction and new-issue CDs without commission. Here’s an example of a simple portfolio using commission-free iShares ETFs at Fidelity:

It’s more expensive than the similar portfolio at Schwab but the cost is still very low.

Are these low minimum index funds and commission-free ETFs loss leaders? Maybe, but they don’t have to be short-lived. There’s enough cross-subsidy at Fidelity and Schwab to make them last.

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Software picked, likely related articles at The Finance Buff:

• Index Funds Or ETFs? How About Both?
• When Are Free Stock Trades Not Free?
• Investing a Small Amount