Mutual Funds vs. ETFs: Which Makes the Most Sense?

Both mutual funds and Exchange Traded Funds (ETFs) offer instant diversification with a basket of stocks, the potential for low costs, and myriad investment options. But which of these collective investment schemes offer the best performance and flexibility after taking costs, taxes, and other criteria into account?

Let's examine the differences, analyze the pros and cons of each, and then lay out when it makes more sense to purchase a mutual fund over an ETF and vice versa. Note that when talking about mutual funds, I will be referencing and referring to low-cost index funds; not their higher cost active fund counterparts. For more on the advantages of index funds over actively managed funds, use google to find articles, pick up a copy of Will McClathy's Index Funds, or continue to read this blog as it will be outlined in a future post.

Mutual Funds

First, the basics. Mutual funds hold a collection of stocks based on the fund's objective and manager's research. Passive index funds offer much lower costs than active funds since they require much less effort and have been shown to outperform active funds after taking fees into account. When buying funds, you purchase shares for the NAV (net asset value) at the end of the day (4 PM ET) no matter when you place the order. That is, if you place the order at 10 AM, 3:30 PM, or even 4:30 PM the day before, your shares will be purchased for the same price at the close of the trading day. Typical index funds offer around a 0.20% net expense ratio (such as the most widely held fund, VFINX Vanguard 500, which offers a 0.18% expense ratio with over $77 billion in assets).

Some funds have front or back-end load, which is a percentage commission paid to the broker when shares are purchased. Others have 12b-1 marketing fees. Avoid these funds. Most brokerage firms charge transaction fees for every time one wants to purchase shares outside of their own firm (e.g. Charles Schwab charges a whopping $49.95 every time an investor wants to purchase shares in VFINX, while charging nada for investing in their equivalent, Schwab S&P 500 Index Inv (SWPIX), which has virtually identical returns and a 0.09% expense ratio). Thus, it makes sense to open a brokerage account directly with the firm that offers the fund. Only invest in no-load, no transaction-fee funds. Mostly for this reason, I have brokerage accounts with Charles Schwab, Vanguard, and Fidelity.

All else being equal, I always choose the fund with the lowest costs (i.e. fees). Vanguard has always been known as the flag bearer of low costs and still wins out with many of its funds, but Schwab recently reduced its fees on its funds to compete with Vanguard. Additionally, most Vanguard funds require a minimum investment of $3,000, while many Schwab funds can be purchased for as little as $100. In any event, the important thing is to open an account directly with the firm that manages the funds.

Exchange Traded Funds

ETFs, on the other hand, trade exactly like stocks. They, like mutual funds, hold a collection of stocks, but unlike mutual funds can be shorted, limit orders can be placed on them, and they dynamically change price throughout the day. Once the trading session has ended, you cannot place a transaction. Since they trade like stocks, there are no minimums, but you have to pay a commission every time you place an order. The prototypical ETF following the S&P 500 is SPY with nearly $64 Billion in assets and an expense ratio of 0.09% (slightly lower than VFINX).

Now, with the knowledge of the basics of mutual funds and ETFs, let's examine the pros and cons of each. Some mutual funds have relatively high minimums that are out of reach for very small investments (however, if you're a small investor, the transaction costs for placing order for ETFs would prove to be prohibitive to positive returns as well), while ETFs have no such minimums. ETFs charge transaction costs for every order placed (even with low commissions from a variety of available brokerage firms), those $9.95 commissions can quickly add up, especially if you're dollar cost averaging. ETFs trade like a stock, so they can be traded intraday, shorted (not recommended for the average investor), can use options (not recommended for the average investor), and limit orders (always recommended for all investors).

Comparison and Conclusion

Mutual funds almost always offer automatic dividend reinvestments for free. ETFs, on the other hand, distribute the dividends in the form of cash in your brokerage account. Thus, you must pay another transaction fee to buy more shares unless your broker allows automatic reinvestment for free (most do and you probably should change if yours doesn't). ETFs also behave in a slightly better way for tax advantage purposes since ETFs avoid the outright selling that triggers undistributed capital gains that plagues mutual funds. Thus, even if you lost money with a mutual fund, you could still be subject to capital gains taxes on top of the loss! Talk about shooting yourself in the foot! But I think these tax advantages, while certainly valid, are often exaggerated. While taxes should be considered, they aren't usually what makes the difference. And if you hold mutual funds in tax-deferred retirement accounts such as a 401(k) or IRA, then you don't have to worry about the tax ramifications at all.

Following is a comparison in table form:

Criteria Mutual Fund ETF Advantage
Min. Investment Varies based on fund None ETF
Transaction Cost Typically none Standard trading fee applies Mutual Fund
Trading Flexibility Purchased for NAV at end of day Trade like stocks; dynamically change price, limit orders, shorts ETF
Dividend Reinvestment Automatic Varies based on broker Mutual Fund
Tax Ramifications May be subject to capital gains even if investment loses money Avoids outright selling ETF
Management Fees Expense ratio ~0.15% for index fund Expense ratio ~0.09% for index ETF ETF

Leonard Kostovetsky, an Assistant Professor of Finance at the University of Rochester, takes the quantitative differences even one step further by looking at the costs inherent in both ETFs and Mutual Funds in his article "Index Mutual Funds and Exchange-Traded Funds," published in the Journal of Portfolio Management (2003). In his Summary of Cost Comparisons, he examines fund transactions, cash drag, dividend policy, rebalancing, management fees, shareholder transaction, and taxation. In the end, Kostovetseky's analysis leads to the conclusion that the costs associated with such criteria favor index funds for most passive individual investors. According to investopedia, if you had a holding period of one year, you would need over $60,000 of an ETF for the fees and taxation benefits to offset the increased transaction costs. With a horizon of ten years, the break-even point would be approximately $13,000.

In conclusion, for the average investor who has a long-term investing strategy and dollar cost averages into their investments, low-cost, no-load, no-transaction fee index funds are the way to go. If you, however, have a large lump sum to invest at one time, then ETFs make more sense due to their slight tax advantages (only relevant in non-retirement accounts) and lower associated fees. Thus, institutional investors with gobs of money should purchase ETFs. In addition, active traders should choose ETFs for their increased trading flexibility as they offer investors the ability to place limit orders (which everybody should do), go short (only experienced traders should go short), use options (only for the experienced), and they dynamically change prices throughout the day.

Update June 2010:  With Charles Schwab, Fidelity, and Vanguard now offering free trading on particular ETFs (8 stock ones for Schwab with 3 bond ETFs in the works, 25 iShares ETFs at Fidelity, and 43 Vanguard ETFs), the above is somewhat outdated assuming you are an index investor.  That is, you can now cheaply dollar cost average into various indexed ETFs assuming you are using transaction-free ones.  Consult each individual site for a specific list.  For those who want to automatically invest an exact dollar amount on a schedule or not deal with limit orders in the middle of your work day and whole shares (you cannot purchase partial shares of ETFs, so the dollar amount won't be even), mutual funds may still offer some more conveniences.  This convenience has to be weighed against the differing cost structure (namely, the net expense ratio) to find the best value.  The difference may be insignificant or may be significant.  Also note that Vanguard has a unique patented mutual fund-ETF structure such that you can convert your mutual fund shares to ETFs absolutely free at a later date if you so choose without realizing any capital gains.  The reverse, however, is not possible.
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