ETFs vs mutual funds

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Exchange-traded funds (ETFs) and mutual funds are two different investment products that you can use to hold a diversified portfolio of stocks, bonds or other assets. There is frequent discussion in the Bogleheads forum on the comparative merits of each. Below is a comparison of various factors, ordered by approximate importance.

Overall, there is no clear winner: it is up to you to consider the tradeoffs, for example ease of use compared to intraday tradeability, and how applicable they are to your own situation and goals.

The choice might not be very important. The media and other literature usually presents the contrast as between ETF investing and traditional, high-cost, active mutual funds, which ETFs easily win on cost. If the funds you are considering are all low-cost index funds, then you are probably fine either way.

Expense ratios

Expense ratios (ERs) are annual management expenses. Because they reduce investor returns, ERs are among the most important factors in long-term performance.

ETFs generally have the lowest ERs available to small investors.

Mutual fund expenses can be somewhat higher, with the exception of Vanguard Admiral funds which are the same, or slightly higher, than their ETFs. The various fees of active mutual funds can be much higher, sometimes outrageous; see Mutual funds and fees for more details.

Examples:

  • VTI (Total stock market ETF): 0.03%, versus VTSAX (Admiral shares fund) at 0.04%.
  • SCHZ (U.S. Aggregate Bond Market ETF): 0.04%, versus SWAGX (fund) 0.04%.
  • DODGX (large active stock fund): 0.52%.

Advantage: ETFs or tie.

Trading costs

These are costs paid once for each trade, whether a sale or a purchase. They are most important for smaller portfolios and frequent investments.

Most brokerages now allow most ETFs to trade commission-free. Some ETFs may incur a small brokerage commission, the same as for stocks, typically in the $5 - $10 range.

ETFs also have a penalty from bid/ask spreads in the market, typically in the range 0.01% - 0.1% (this varies with fund size and popularity) and a premium or discount to net asset value (NAV) that can vary from negligible to highly significant. In some illiquid sectors, like municipal bonds, persistent ETF discounts can prevent selling at a fair price for an extended period.[1]

Mutual funds are more often bought at their originating firm, where they have no commission. If bought at a different brokerage, fees can be much higher, for example $50 per transaction, with some agreements to waive fees from certain fund families. It is very important to select either the account location or the fund to avoid large transaction fees.

Mutual funds always trade at NAV and do not have bid/ask spreads or premium/discounts.

Advantage: Mutual funds, if bought directly from a fund provider or a brokerage that offers the fund in their "no transaction fee" selection.

Trading frequency

This refers to possible timing restrictions.

ETFs can be traded at any time during the day, more or less instantaneously. The downside is a two day settlement time during which sale proceeds cannot be removed from the account. Some brokerages charge fees when you turn around ETFs they normally offer commission-free within a short period (for example, TD Ameritrade and Fidelity). Still, ETFs are the vehicle of choice for frequent traders.

Mutual funds can only be bought at the end of the day. The settlement time is shorter, however: one day or even immediately by routing sale proceeds to an external account.

Most mutual funds also have additional fees or restrictions for back-and-forth trades less than a few months apart. For example, Vanguard will restrict purchases in most funds for 30 days after a sale, see Frequent trading policy for the policy and workarounds. Other funds charge a redemption fee for shares held less than 90 days. Because of these restrictions, mutual funds are only suitable for longer term holdings.

Advantage: ETFs are generally more flexible.

Tax efficiency

Both kinds of funds sometimes distribute capital gains to holders, and this is undesirable in a taxable account (for stocks, at least). For more details, see Tax efficiency of stocks.

ETFs have an inherent tax efficiency advantage due to their share redemption process (see ETF Taxes). Other things equal, you can expect an ETF to distribute lower capital gains than its mutual fund equivalent, often none at all.

Mutual funds can only rarely eliminate capital gains in the same fashion. The exception is Vanguard's dual-share fund structure, which allows their index funds to be just as tax-efficient as ETFs. In addition, index funds in general have very low turnover, limiting the extent of the problem.

Advantage: ETFs, or tie if Vanguard.

Trading mechanics

How easy it is to transact either type of fund.

ETFs tend to require more attention, because the bid/ask spread and premium/discount factors mentioned in Trading costs can turn highly unfavorable for short intervals. For example, you want to use limit orders instead of market orders. On the other hand, ETFs provide more sophisticated order options like long term stop-loss orders (the value of which is rather debatable). You can also use covered options with ETFs.

Automatic investments can be problematic with ETFs; this includes things like dividend reinvestment and monthly deposits or withdrawals. Even when the broker offers this functionality for free, the execution price might not be favorable to you.

In addition, buying ETFs usually involves share number calculations.

Mutual funds can be bought and sold in a single, friction-less transaction, much like transferring from one bank account to another. They are much more suitable for automatic investment of all kinds.

Advantage: Mutual funds, for most investors.

Availability and portability

Access to the two types of fund can vary greatly between accounts. For taxable investments, this can be an important factor if you plan to move assets in the future without incurring tax.

ETFs are generally an all-or-none proposition: a brokerage will offer access to all ETFs in the market. Unless a brokerage option is available (for example, in retirement accounts), you cannot use ETFs.

It is generally easier to make charitable donations of ETFs in-kind, because the brokerage of the charity should always be able to handle them.

Mutual funds tend to be more restricted; for example Schwab may offer easy, free access to Schwab funds but make Vanguard funds expensive or not available at all (such as Admiral shares). Charities and other brokers may not be able to receive a particular mutual fund in-kind.

However, Vanguard index funds offer an ETF conversion option that solves this problem, for assets held at Vanguard.

Advantage: ETFs.

Intraday pricing

ETFs have price and related indicators (like yield) that are constantly updated throughout the trading day. This makes it easier to make accurate decisions about rebalancing and tax loss harvesting, for example. However, when the market is closed the price is just as opaque; the next day's opening price (at which a market order would be executed) could move up or down an arbitrary amount.

Mutual fund prices are only updated after the market close, typically 4 pm EST. A workaround for funds that are closely related to certain ETFs is to extrapolate the mutual fund price from the intraday movement of the ETF price. If you want precision, it is best to place the order shortly before the market close to minimize the chance of market shifts during the remainder of the trading day.

Advantage: ETFs.

Fractional shares

Many brokerages only let you buy ETFs in whole share amounts. Typically, this results in small amounts of cash left over uninvested, which can be an annoyance. When starting with a dollar amount, you have to calculate the number of shares you can buy before placing an order.

Some brokers let you buy fractional ETF shares. Bear in mind that if you decide to move your account to another broker which does not support fractional shares, you may have to sell your fractional shares and pay a tax on the gain.[2]

Mutual funds can be bought and held in any fractional number. The order can be specified as either dollars or number of shares, and there are no leftover amounts.

Advantage: Mutual funds.

Coverage

This is the ability to get the asset classes and strategies you want in either form. Because it can be inconvenient to move money between ETFs and mutual funds, coverage can be a factor even when your initial choices are equally available.

ETFs tend to offer the largest asset class selection and granularity in passive form. For example, there are ETFs available for Middle East indexing, or the solar sector, which have corresponding mutual funds.

Mutual funds offer more strategies, for example active funds, balanced funds or go-anywhere funds. Of these, balanced funds are the most interesting to passive investors.

Advantage: Depends on investor goals.

Vanguard funds

Vanguard structures its ETFs as another share class of a mutual fund, like Admiral or Investor shares. This process is unique to Vanguard, protected by a patent until 2023, with two important consequences for the mutual fund investor:

  1. Tax efficiency: the mutual fund shares benefit from the disposition of capital gains through ETF shares, making Vanguard funds with ETF share classes as efficient as an ETF.
  2. Conversion: you can convert mutual fund shares to ETF shares without a taxable event. This helps if you transfer assets to another broker, including charitable donations. Conversion in the other direction is not possible.

The second point is an argument to start with mutual fund shares at Vanguard, if unsure. You can always convert to ETF later if needed.

To find out whether a mutual fund has ETF shares, visit the fund page on vanguard.com and look for "Also available as an ETF". Most or all index funds do have ETF shares and benefit from the above considerations. Note that you cannot convert a few bond funds in kind to their ETF shares, but in these cases converting through a normal, taxable transaction will probably not cost much in taxes because of the very limited capital gains of this type of fund.

Vanguard's Admiral shares of index funds generally have the same, or slightly higher expense ratios as the ETF shares, which are themselves competitively priced in the ETF market. Therefore, if Admiral shares are available and you meet the required minimum (usually $3,000), there is no, or only a small, fee advantage for using ETFs.

See also

References

  1. Rick Ferri (June 27, 2013). "Solving The Bond ETF Discount Problem". Archived from the original on August 4, 2013.
  2. "Can Fractional Shares Be Purchased in an ETF?". Zacks. March 6, 2019. Retrieved September 1, 2023.

Further reading

External links