September 2, 2014

ETFs vs Mutual Funds

It's no surprise that I generally favor exchange-traded funds over their mutual fund cousins. The king of indexing, Vanguard, often has ETF versions of most its mutual fund offerings, so investors can pick whichever investing vehicle they prefer. I usually favor Schwab and Vanguard ETFs due to their dirt-cheap expense ratios and access to most major asset classes (and commission-free trading!). It looks like I'm not alone. Last year Schwab ETF assets grew to $196 billion, up 29% compared to growth of 26% for the industry as a whole. Vanguard's assets swelled to over $3 billion this month after a mention from Warren Buffett. As expected, Vanguard's actively managed funds have continued losing ground to those investments tied to a passive indexing strategy. Just over $11 billion of its $130 billion in inflows went toward active funds. Notably, however, the firm's index mutual funds totaled nearly twice the inflows of its index exchange-traded products.

We know indexing is continuing to grow and the ETF industry is exploding (awesome infographic!), in both the number of funds an assets under management. Nevertheless, mutual funds aren't going anywhere anytime soon. In fact, the the U.S. mutual fund industry has been around since the late 1800s and currently holds $15 trillion in assets! That's nearly nine times the size of the much younger (nearly 20-year-old) U.S. ETF industry, with nearly $1.7 trillion.

Photo by Lonpicman is licensed under CC BY-SA 3.0, Text added to original
That bit of background behind us, let's take a look at some of the major differences between the two investment vehicles.

Comparing Vanguard expense ratios for large, mid, small, international, emerging markets, and bond funds.Expense Ratios: When comparing identical mutual and exchange-traded versions of the same funds, the exchange-traded variety almost always has lower expenses. Using Vanguard funds for comparison, you'll see that the company's ETFs are nearly always the low-cost leaders or very close to it. Vanguard's mutual funds are very affordable as well (these expenses are for Investor Shares), but you'll need to invest at least $10,000 in any index fund to qualify for the Admiral Shares expenses that usually match their corresponding ETF costs. If you're interested in an actively managed fund, that minimum jumps to $50,000. With an ETF, there are no minimums to worry about. Ultimately the chart above probably understates the cost advantage of ETFs. Many mutuals funds charge well in excess of 1% or even 1.5% while a huge variety of passive exchange-traded funds charge well south of 0.5% (or even just a tiny fraction of it).

Trading Costs: Traditionally mutual funds have had an edge in this regard. With no-load funds, investors are easily able to dollar cost average into an investment without worrying about getting hit with trading commissions each time. Back in the early days of ETFs, spending $30 per trade would have eaten into small investors' profits if they wanted to add to their holdings on a regular basis. Trading commissions at established brokers were often many multiples of what's available today, although E*TRADE and Ameritrade began applying pressure to bring prices down across the industry. But now, with such a massive selection of commission-free ETFs, this disadvantage has largely disappeared.

Trading Flexibility: Exchange-traded funds, by their very nature, are liquid and available for trading anytime the markets are open. I prefer to limit my focus to ETFs that have both large net assets and trading volume, meaning it's easy to buy when I want and at very narrow bid/ask spreads. Mutual funds on the other hand are sold at whatever the net asset value (NAV) is at the end of the day, calculated only once per day. Now, if you're a long-term investor, it's really not a big deal to have the ability to purchase shares throughout the day. Timing the market is all but impossible for mere mortals, so trading sometime earlier in a trading session isn't particularly more advantageous. But some may like knowing they can. For undisciplined investors, I suppose it's possible to be tempted into making knee-jerk reaction trades just because they can, but regardless, the edge goes to ETFs.

Taxes: Mutual funds are generally less tax efficient. As investor money flows in or out of a traditional mutual fund, the fund itself may have taxable events. These events impact investors in the fund whether or not they themselves have sold their investment. As such, there's less control for individual mutual fund investors and they may find themselves impacted negatively by others who have left the fund. However, mutual funds can also take advantage of capital losses. Active mutual funds with lots of turnover may be more particularly prone to negative tax effects, although passive index funds are generally pretty tax efficient. Conversely, the ETF creation and redemption process generates in-kind trades that don't typically have any tax implications for the fund. So ETF investors usually only have to worry about taxes when they themselves sell shares, giving them much more control over the process. As far as dividends are concerned, investors in both fund types have to pay capital gains taxes regardless of whether or not the dividends were reinvested (at the long-term rate for securities purchased 60 days prior to the ex-dividend date, or at ordinary income rates for funds held less than that).

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