ETF vs Index Funds

ETFs resemble index-based mutual funds in that both represent baskets of securities that track the performance of an index. However, there are key differences between ETFs and index funds, including how they trade, what they cost and what they can do.

In short, I am a proponent of ETF (Exchange Traded Fund).

Benefits:

1. Liquidity

Bid/ask spread is minimal and we can buy ETFs using intraday quote; whereas, Index Fund can only be bought/sold at the end of day price quote.

2. Cost 

Expense ratio of ETF is cheaper than Index Fund; for instance, the expense ratio for Vanguard's Total Stock Market ETF (VTI) is .07%, compared with an expense ratio of 0.19% for the firm's VTSMX Total Stock Market Index Fund.

In addition, ETFs have no minimum investment requirements and no fees for early withdrawals. If you are using discount brokers, the commission of buying/selling ETFs is cheaper than that of Index Fund.

3. Tax efficiency

ETFs are generally more tax-efficient than index mutual funds. When a large investor wants to cash out of a mutual fund, the portfolio manager often has to sell shares in the fund to raise the money. This generates a capital gain distribution, which is taxable to shareholders.

ETFs, though, are sold on the open market, so when an investor wants to cash out, he can just sell his shares without affecting other shareholders.

ETFs may, however, incur capital gain distributions if, say, the fund needs to sell securities when it rebalances. Because of the ETF structure, though, capital gains can often be minimized or avoided altogether.