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ETFs vs. Index Mutual Funds

 

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Exchange Traded Funds (ETFs) have recently become somewhat popular.  At their heart, they are basically just index mutual funds which are bought and sold as stocks.  In that way, they are similar to closed-end mutual funds which happen to be index funds.  However, they have several interesting features which make them more similar to conventional (open-end) index mutual funds.

An obvious question is, "Which should I use, ETFs or conventional index mutual funds?"

This web page lists pros and cons of ETFs as compared to conventional index mutual funds.  For articles and papers discussing ETFs, see here.

ETF Pros

bulletSome ETFs may have lower expense ratios than similar conventional index mutual funds.  If true, this suggests that ongoing expenses would be lower, which favors ETFs.  However, note that most ETFs have expense ratios which are not dramatically lower than the lowest cost conventional index mutual funds with similar investment goals.

bulletETFs may be somewhat more tax efficient than similar conventional index mutual funds.  This increased tax-efficiency is in the form of lesser capital gains distributions (which effectively means that an ETF's capital gains tend to be more deferred than a similar mutual fund's would be).  The idea that ETFs should have lower capital gains distributions comes from their ability to shed their lowest-basis shares to institutional arbitrageurs through in-kind redemptions.  Note that this benefit applies to a much lesser extent to Vanguard's ETFs.  Because they exist as a separate share class of conventional mutual funds, any tax benefit a Vanguard ETF generates is shared by investors in the fund's non-ETF shares, thus diluting the beneficial effect for Vanguard ETF share owners.

bulletETFs may have somewhat less "cash drag" than similar conventional mutual funds.  Conventional mutual funds typically need to maintain a small amount of their portfolio in cash in order to meet ongoing cash redemptions.  An ETF has no such need because it never has to deal with the possibility of cash redemptions.  This may provide a slight advantage for ETFs over similar index mutual funds.

Note that if the ETF you are considering has a higher expense ratio than any similar conventional no-load index mutual fund AND the prospective ETF investment would not be in a taxable account (e.g., you are in an IRA), then ETFs are likely to underperform the alternative (due to its higher fees) and you should abandon the idea of using the ETF in favor of the alternative.

ETF Cons

bulletWhen you buy or sell an ETF, you must buy/sell it on the open market, like a stock.  When doing so, you must specify an order type (e.g., market, limit, etc.) and an execution price (if it's not a market order).

If you enter a "market" order, particularly for large orders, you may get quite poor execution prices, suggesting a large implicit (i.e., effective) transaction fee.

If you enter a "limit" order, the price you enter may not get you execution in the near future, perhaps causing you to have to re-price your order to a less desirable price in order to increase the chances of getting execution in the near-future.  This tends to cause increased "cash drag" and another potentially large implicit transaction fee.

In our opinion, this may be the biggest "con" to consider for ETFs.  It is both dramatically simpler, and often less costly, to buy a similar no-load open-end index fund.

bulletWhen you buy or sell an ETF, you implicitly pay (as a "hidden" fee) one-half of the ETF's "bid-ask spread."  Bid-ask spread is the difference in price between the market price for buying the ETF and the market price for selling the ETF at any point in time.  Note that, for a conventional no-load mutual fund, there is no bid-ask spread involved.

An ETF's bid-ask spread can be quite small (e.g., for domestic large-cap stock ETFs) or quite large (e.g., for new and thinly-traded ETFs).

bulletETFs may not be as tax efficient as you'd like.  At present, qualifying dividend distributions from stocks are taxed at a preferentially low tax rate in the United States.  One of the requirements to qualify for this low rate is that the stock has been held for at least 60 days.  Due to share creation activity, this standard may not be met all the time.  Thus, a portion of the dividend income received (and distributed) by the ETF may not qualify for the preferentially low tax rate for qualifying dividends.

Conventional index mutual funds have more control over this than do ETFs, and are therefore more likely to have a higher percentage of their distributed dividends qualify for the preferentially low tax rate.

bulletETFs won't track indexes as well as conventional index mutual funds.  A mutual fund's share price is always, by definition, the fund's net asset value (NAV).  The NAV is just the weighted-average current market value of all the fund's holdings, expressed on a per-share basis.

An ETF, on the other hand, is valued by the market.  So even if its holdings are EXACTLY consistent with those of the index, its market price at any particular time can be either above or below the NAV (meaning it can be sold at either a higher or lower price than the per-share value of its underlying securities).

The difference between NAV and market price for an ETF won't ever be very high because institutional arbitrageurs are able to either create or redeem shares of the ETF using the underlying stocks.  This tends to drive the ETF price back towards its NAV.  However, this tracking error is likely to be higher for ETFs which hold less liquid securities (e.g., emerging markets stocks).

bulletThere are relatively few bond ETF options available at present.  However, note that ETFs are less desirable for bonds anyway since a relatively small portion of a bond's total return is due to capital gains, the tax efficiency benefit of bond ETFs is relatively trivial.

bulletIf the ETF is organized as a Unit Investment Trust (e.g., the original SPDR ETF), then all dividends the fund receives are required to be held in a non-interest bearing account until distributed to investors.  This causes a "cash-drag" on the fund's earnings which conventional index mutual funds (and non-UIT ETFs) don't experience.
 
bulletMany investors choose to have distributions of conventional mutual funds automatically reinvested in additional shares of the fund.  This is convenient it keeps your money working for you without requiring extra effort on your part to redeploy the distributions.

On the other hand, ETFs generally don't have this as an alternative.  They pay out distributions as cash.  If you want to then reinvest that cash, you need to take some action to do so (and incur whatever transaction costs apply).

bulletApparently, you can only buy/sell ETFs in whole share lots.  In other words, while you can buy exactly $5,849.23 of some mutual fund, you can't necessarily buy that much in an ETF you have to buy whole shares (not fractional shares).  This isn't a big deal, you just have a bit less flexibility and there may be a little more "cash-drag" in your account if you use ETFs instead of mutual funds.  But then again, ETFs tend to hold lesser amounts of cash themselves (since they don't have to keep cash on hand to meet cash redemptions, as do mutual funds).

Overall, some ETFs may make sense for some situations.  However, ETFs are not the panacea that many advocates claim them to be.

This web page contains the current opinions of Eric E. Haas at the time it is written and such opinions are subject to change without notice.  This web page is intended to serve two purposes:

bulletTo educate the public; and
bulletTo provide disclosure of Mr. Haas' opinions to prospective clients.  We believe that prospective clients are well-served by being made aware of what they are buying and what they are buying is advice that is based on these opinions.

We believe the information provided here to be useful and accurate at the time it is written.  Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. 

No investor should invest solely on the basis of information listed here.  Before investing, it is important to consult each prospective investment's prospectus and consider both its risk/return characteristics and its effect on your overall portfolio.

This information is not intended to be a substitute for specific individualized tax, legal, or investment planning advice.  Where specific advice is necessary or appropriate, Altruist recommends consultation with a qualified tax adviser, CPA, financial planner, or investment adviser.  If you would like to discuss the rationale or support for any particular idea expressed on this web page, feel free to contact us.

 

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