ETFs vs mutual funds
An exchange-traded fund (ETF) is a form of mutual fund. There is frequent discussion in the Bogleheads forum on the comparative merits of ETFs and mutual funds. User livesoft has offered a succinct summary below.
Pros of ETFs
- Generally lower expense ratios and can purchase less than the minimums needed for some mutual funds.
- More tax-efficient than even identical mutual funds (except for Vanguard's): ETFs can get rid of capital gains when shares are redeemed, resulting in less or no capital gain distributions.
- A good broker like WellsFargo or Fidelity make tax-loss harvesting and bookkeeping trivial since one can easily use specific share id (but they can do this with mutual fund shares as well).
- Can use limit orders so you know exactly what you are paying.
- Can purchase during the day at known prices without waiting for the close of the market session.
- Asset classes available that an entity like Vanguard does not have in their mutual funds.
- One can take advantage of occasional anomalies and purchase shares at a lower than expected price.
- No frequent trading restrictions.
Cons of ETFs
- Some brokers charge a commission. Not a problem with brokers which do not charge a commission.
- The bid-ask spread confuses some people, but we have seen it can be small or one can be taken advantage of.
- No real way to get a fair price when the market is closed.
- Must buy integral number of shares ... cannot typically buy fractional shares (though some brokers allow this, but they are not no-commission brokers).
- Automatic investment is problematic. Your broker may have this functionality, but would you trust their prices? (Do not confuse automatic investment with automatic re-investment of distributions.)
- Some possible friction when tax-loss harvesting since one usually sells one fund and then buys another. (It is possible to buy first and double-up, then sell later. This can be done with mutual funds as well.)
- One can stupidly submit orders to sell when the market is closed or use stop-loss orders that get taken advantage of. Or one can make other errors entering orders.
Pros of mutual funds
- Can buy fractional shares; all your money goes into shares without leftovers.
- Automatic investment is easy.
- Trades execute at end-of-day net asset value (NAV).
- Exchange from one fund to another has no friction since both sell & buy done at end-of-day NAV.
- Can submit orders when the market is closed. You will get a fair price at the next available NAV.
- Dividends re-invested the same day they are paid at NAV.
Cons of mutual funds
- Expense ratios can be (not always) higher than corresponding ETF.
- No intraday transactions.
- Usually must submit the order before the end of the trading day. The actual price is not known (but is legally guaranteed to be the NAV).
- Lack of some asset classes without excessive fees.
- Some funds have trading restrictions (cannot re-buy after selling for NN days).
- Less portable than ETFs: another broker may not provide access to a certain fund, when transferring or donating assets in-kind. This is less of a problem with most Vanguard index funds, which can be converted to ETF shares without a taxable event.
Vanguard ETFs are structured as another share class of a mutual fund, like Admiral or Investor shares. This is a process unique to Vanguard, protected by a patent until 2023, with two important consequences for the mutual fund investor:
- 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.
- Conversion: mutual fund shares can be converted to ETF shares without a taxable event. This helps when transferring 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, if unsure. One 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.
Vanguard's Admiral shares of index funds generally have the same expense ratios as the ETF shares, which are themselves competitively priced in the ETF market. Therefore, if Admiral shares are available and one meets the required minimum (usually $10,000), there is no fee advantage for using ETFs. Before hitting the $10,000 mark, the cost difference is small in absolute terms, for example:
|Emerging Markets Index Fund Investor Shares VEIEX||ER 0.33%||$33 per $10K per year|
|ETF version VWO or Admiral version VEMAX||ER 0.15%||$15 per $10K per year|
|ETF cost savings before Investor shares convert to Admiral||0.18%||$18 per year maximum|
- Both mutual funds and ETFs allow free automatic re-investment of distributions. It is really a broker function --- not a function of the investment.
- Both ETFs and mutual funds can be tax efficient ... or not.
- Each investor will need to assign value to the advantages important to them and subtract value of the disadvantages important to them. ETFs are not a slam dunk. Neither are mutual funds.
- The basics of ETFs: A primer for the perplexed is Vanguard's introduction to the topic.
- The Choice Between ETFs and Conventional Index Fund Shares is Vanguard's in-depth look.
- Become a Better Index Investor. A 50 minute video which digs into the ETF versus index fund debate. By Christine Benz of Morningstar.com, March 22, 2014.