Mutual Funds Versus Exchange Traded Funds

Many beginning investors wonder if they should be investing in traditional mutual funds (TMF) or exchange traded funds (ETF). Once they learn a little more, they discover it matters far more that they are investing in the right kind of mutual funds (low-cost index funds) and doing it the right way (buying and holding a diversified collection), rather than whether the fund is traded on an exchange or not. Nevertheless, there are some subtle differences between the two that may help you to decide which one to use in your circumstances.

Upsides and Downsides of ETFs

ETF proponents claim better tax-efficiency, higher transparency, lower average fees, intraday liquidity, and insulation from forced buying and selling as strengths of ETFs. Their detractors point out spreads, premiums and discounts, tracking errors, and difficulties with dividend reinvestment. This, of course, ignores the primary argument against ETFs—that speculators are far more likely than long term investors to use ETFs. As John Bogle, founder of Vanguard, has said, “I freely concede that the ETF is the greatest marketing innovation of the 21st century. But is the ETF a great innovation that serves investors? I strongly doubt it. For better or for worse, ETFs have opened indexing to a new market of stock traders. The only sure winners are the brokers and dealers of Wall Street.”

However, in this article I’m talking about using ETFs as a long-term investing tool, not a speculating tool. One can speculate using either type of fund, even if it is more easily done using ETFs.

Each of the arguments for and against ETFs as an investing tool has subtleties worth looking into.

ETF Benefits

ETF proponents claim a number of benefits of an ETF over a TMF, although these benefits are often oversold for the purposes of a long-term buy and hold investor.

Better Tax-Efficiency. Due to the unique ETF structure, it is easier to flush capital gains out of an ETF than a TMF rather than passing them on to the investor. However, this doesn't matter to an investor in a tax protected account like a 401(k) or a Roth IRA. This especially doesn't matter with the unique Vanguard funds, where the ETFs are a share class of the TMF. In fact, that structure offers the best of both worlds, where the gains can be flushed out of the ETF share class, saving taxes for holders of both the ETF and the TMF share classes.

Higher Transparency. TMFs only have to tell you what they actually own twice a year. It is much easier to see what an ETF is holding as its respective components are available in real time. However, if your investments are primarily in index funds (as they should be), it's pretty obvious what the fund is holding at any given time.

Lower Average Fees. While ETFs, on average, do have lower expense ratios than TMFs, the averages really don't matter much. What matters is how much you are paying. And the best ETFs and TMFs have very low expenses anyway. For example, the admiral shares of the Vanguard Total Stock Market Index Fund have an expense ratio of 0.05% per year, exactly the same as the ETF shares. In addition to the expense ratio, ETF investors also have to deal with the costs for spreads, premiums and discounts, and commissions, so even a slightly lower expense ratio may not make up for those.

Insulation from Forced Buying and Selling. ETF proponents correctly point out that in a time of market turmoil, many investors panic and pull their money out of their investments. A TMF is often forced to sell securities at fire sale prices in order to meet their redemption needs. They may also need to carry a higher percentage of cash to meet redemptions, lowering returns in bull markets. This effect can be minimized by investing in funds held primarily by intelligent, buy and hold investors, like index funds, which tend to have lower turnover during bear markets.

ETF Shortcomings

ETFs have their downsides as well, although most of these can be minimized relatively easily.

Paying the spread. When you buy or sell anything on the open exchange, there is a spread. For example, at any given time you may be able to buy shares at $41.09, but only be able to sell them at $41.01. That 8-cent gap is the spread. With infrequently traded stocks or ETFs, the spreads can be quite wide. However, you can minimize the spread by purchasing only very liquid ETFs. For example, as I write this, the spread on VTI (the ETF shares of the Vanguard Total Stock Market Index Fund) is 2 cents, from $106.78 to $106.80. That represents about 0.02% of your purchase, almost insignificant (although about 40% as large as the expense ratio for the entire year.) A less frequently traded ETF, such as PDH (Powershares DWA HealthCare Momentum ETF), has a spread of 27 cents, from $54.76 to $55.03, or about 0.5% of your purchase, 25 times as much as VTI.

Premiums and Discounts. Sometimes ETFs are not sold for the same price as the total of the underlying securities in the ETF (Net Asset Value or NAV). While ETFs have a mechanism to correct this problem, in times of severe market volatility, this mechanism can break down. A TMF never has this issue, as its price equals the NAV at the end of every day. This issue can be minimized simply by avoiding trading during periods of high market volatility or when the premium or discount is not in your favor.

Tracking Error. This is really an issue with any index fund, whether exchange-traded or not. The less liquid the asset class, and the more expensive the fund, the higher the difference between the fund’s performance and the index performance will be.

Dividend Reinvestment. One of the most convenient aspects of a TMF is that you can just have the dividends reinvested automatically. Although this may not be a good idea in a taxable account, as it creates a lot of small tax lots to keep track of, it is very useful in a tax-protected retirement account. Unfortunately, this feature is generally not available for ETFs (although some brokerages are starting to offer this feature, but sometimes only for their own ETFs). Dividends must be reinvested manually. This introduces additional hassle and costs (primarily spreads and trading commissions).

Practically Speaking

Most smart investors choose between ETFs and TMFs based on the practical issues—cost and hassle. Let me show you what I mean. In my 401(k), I can invest my money into a handful of low-cost Vanguard index funds and pay a 401(k) fee of 0.3% per year to the 401(k) company. Alternatively, I can invest my money in anything available through the Charles Schwab brokerage for $200 per year, plus $8.99 per trade. At a certain level of assets ($70-100,000), the 0.3% fee is higher than the flat fees. So when my 401(k) hit that size, I switched. I choose to invest in the ETF version of the same or similar Vanguard index funds available in the 401(k) already, but at a lower price.

In this situation, the supposed advantages of ETFs don't matter at all. I don't need tax-efficiency, as the money in a 401(k) grows in a tax-protected manner. Transparency doesn't matter to me, as both the traditional index funds and their respective ETFs hold the exact same securities, and everyone knows what they are—all of the securities. The fees on the investments themselves are exactly the same. I certainly don't need intraday liquidity, as I don't need this money for decades. In fact, if the costs to me were the same, I would prefer the traditional mutual fund, as I wouldn't have to go through the hassle of placing buy orders, nor have to reinvest dividends manually. But I'm not willing to pay hundreds or even thousands more in 401(k) fees in order to do so.

There are also times when the investment you want is only available as an ETF, or only as a TMF. In these cases, the investor will have to use what is available, or choose a different fund or asset class.

The bottom line is that you can use either traditional mutual funds or ETFs to invest in a reasonable, low-cost manner. You should choose based primarily on cost and amount of hassle.

Dr. Dahle is not an accountant, attorney, insurance agent, or financial advisor. He blogs as The White Coat Investor and is the author of the best-selling The White Coat Investor: A Doctor’s Guide to Personal Finance and Investing.