These index funds and ETFs provide a lot of diversification at a very low cost.
By Christine Benz | 04-22-15 | 06:00 AM | Email Article

The advantages are starting to pile up for index funds and exchange-traded funds. 

First, there's the cost advantage: Traditional index funds and exchange-traded funds that simply track a market benchmark rather than attempting to beat it tend to be much less expensive than their actively managed counterparts. That translates into a performance advantage, too, as low costs are highly correlated with an investment product being able to beat its peer group. A portfolio of ETFs and/or index funds can be easy to set up and oversee, and equity index funds and ETFs tend to be more tax-efficient than active funds, too. 

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

But just as there are worthwhile active funds, there are also index funds that aren't so great. Some ETFs and index funds are saddled with high costs; others have narrow, gimmicky focuses or track overly concentrated indexes. 

In short, index investors benefit from being selective. Shopping for the cheapest index funds and ETFs is a good starting point--and not the worst ending point, either. After all, core benchmark-trackers are virtually interchangeable; expenses will be the major differentiator. But investors should also pay attention to matters such as the construction of the index a fund tracks, as well as how closely it tracks it. 

Would-be index-fund investors should also carefully consider product type: Are they better off with an ETF or a traditional index fund? Exchange-traded funds carry some potential tax benefits for investors in taxable accounts and for those who want to trade intraday. But for investors in tax-sheltered accounts such as IRAs, or for those who don't value intraday trading, ETFs and traditional index funds will be fungible. And traditional index funds may be better in some instances, such as if the investor is making frequent small purchases. Adam Zoll discusses the pros and cons of index and traditional mutual funds here; in this article, he discusses some of the key questions to ask when deciding on an index product. 

Here's an overview of Morningstar's top index-fund and ETF picks in each of the major asset classes. Premium Members: Click here to access the rest of this article. If you're not a Premium Member, you can try Premium free for 14 days.

 

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