Since their introduction in 1993, Exchange-Traded Funds (ETFs) have steadily taken market share from index-based mutual funds. Today they account for 40% of the index fund marketplace and show no signs of slowing down. These baskets of securities that passively track an index (in most cases) and trade throughout the day like stocks have profoundly impacted the investment industry. Active traders take advantage of the stock-like features of ETFs: limit order purchasing, shorting, and options. For the index investor, the low ongoing costs of ETFs represent an opportunity to squeeze greater returns from a buy-hold-rebalance portfolio.
It's important to keep the ETF-mutual fund decision in perspective. Your choice of investment vehicle will have much less of an impact on your portfolio's long-term performance than your ability to build and faithfully implement a risk-appropriate asset allocation plan. That being said, if you already have a long-term investment plan and you wish to maximize your chances of achieving your financial goals, this article can help you determine whether ETF investing is right for you.
The most glaring advantage of ETFs over mutual funds is their lower expense ratios. Comparing a popular basket of domestic and international index funds with their ETF counterparts, the ETFs have an average expense ratio advantage of .11% annually. This advantage obviously becomes more meaningful when a large initial investment grows undisturbed over several years. While ETF-like expense ratios are available through exclusive mutual fund share classes like Vanguard's Admiral Class ($100,000 investment generally required), ETFs clearly have lower ongoing costs than most comparable mutual funds.
ETFs are also more tax efficient than mutual funds. The process of creating and redeeming new shares "in-kind" allows most ETFs to unload low cost-basis shares and theoretically eliminate unwanted capital gains distributions. Additionally, for tax loss harvesters, the vast number of ETF choices allows for efficient swapping of capital-losing funds for suitable alternatives.
Finally, ETFs have a significant advantage in trading flexibility. Since ETFs are traded through brokers instead of fund companies, an investor can buy an ETF on any platform at any time of day. Daily holdings reports and up-to-the-minute estimates of underlying fund value (Intraday Indicative Value, or IIV) give ETF shoppers the transparency they need. Although trading costs must be considered, the fund minimums and redemption fees often associated with mutual funds do not apply to ETFs. Additionally, the ability to specify trading prices through limit orders can help to maintain a precise allocation.
Mutual Fund Advantages
While ETFs can boast of low ongoing expenses, mutual funds have a clear advantage in transaction costs. In general, mutual funds can be purchased commission-free through their fund company with relatively low investment minimums and automatic dividend reinvestment. On the contrary, ETF purchasers must pay a trading commission for each brokerage transaction (including dividend reinvestments, in some cases) and must also consider the bid/ask spread, or the difference between what a buyer is willing to pay for a security and the seller's offer price. Commissions are typically between $5 and $25 per trade, while bid/ask spreads vary based on an ETF's liquidity. Among a popular basket of domestic and international ETFs, the average bid/ask spread cost is typically between .01% and .04% of the transaction value. Investors must exercise caution when trading spreads are more than a few cents as an ETF's market price can deviate significantly from the underlying value of its holdings (NAV).
Many would argue that the mutual fund structure encourages good investing behavior. For instance, commission-free trading facilitates a dollar-cost averaging strategy, or the practice of investing a fixed dollar amount on a regular schedule in order to purchase a greater number of low-priced shares. An investor who doesn't pay transaction costs also doesn't hesitate to perform a rebalancing trade when his portfolio deviates from a risk-appropriate allocation; a transaction cost might cause him to delay this important action. Prominent indexing advocates like John Bogle and Warren Buffett have voiced concern that ETF trading could cause investors to stray from a long-term, disciplined investing approach.
Your unique circumstances and priorities can help you determine which investment vehicle offers you the greatest chance of financial success. For many index investors, cost considerations drive the majority of investment decisions. Vanguard's ETF-Mutual Fund comparison tool can help you weigh the upfront cost advantage of mutual funds versus the low ongoing expenses of ETFs. This tool generates hypothetical returns for Vanguard's ETF and mutual fund share classes based on your initial investment, expected holding period, trading frequency and commission rate. Be sure to consider future Admiral Share eligibility when analyzing the output.
Like many investors, you may find that cost considerations alone don't produce a clear winner. If ETFs are an obvious choice for some investments while mutual funds are best for others, look to non-cost factors to make your decision. For instance, if you value trading flexibility and fund variety, an ETF portfolio through an online brokerage firm may be a logical choice. Alternatively, an appreciation for simplicity or the need for philosophical alignment may lead you to do business with a single fund company. A true cost-minimizer who can manage an added layer of complexity in his portfolio may decide to split his investments among multiple account providers (e.g., a tax-sheltered mutual fund account with Vanguard and a taxable account with a low-cost online brokerage firm for ETF purchases).
Whether you decide on ETFs, mutual funds, or a mix of both in your portfolio, it's important to keep this decision in perspective. Your ability to faithfully maintain a diversified, risk-appropriate asset allocation will play a much larger role in determining your financial success than your choice of investment vehicle.