In the majority of the posts to date, I have limited the analysis of the different investment instruments that can be used to satisfy the different asset allocation components to index mutual funds. Please see link below for more details.
My Money Blog – Mutual Fund Posts
However, in one post back in January of this year, I introduced the idea of using ETFs (Exchange Traded Funds) to invest if you are just starting out and only have a relatively low amount of money ($100-$3000).
Not included in this article was an explanation of what an ETF exactly is and how they stack up against regular index mutual funds. These topics will be the subjects of today’s post.
Note: Even though there are both ETFs and mutual funds that are actively managed, we are going to only focus on the index version of each of these, since we have learned previously that actively managed funds do not outperform the market.
What exactly is an ETF?
According to Investopedia.com (see link below for more information), an ETF, or Exchange Traded Fund, is an investment instrument that is very similar to a mutual fund, but is traded like an individual stock.
When you purchase a share of an ETF, your money is pooled with other investors’ funds, which are then used to buy shares of numerous individuals stocks, in order to be representative of an index (such as the S&P500) of which the ETF seeks to track. In this way, an ETF is very similar to a mutual fund.
However, the pricing of an ETF is set throughout the day by the market demand/supply (not based on Net Asset Value at the end of the day like a mutual fund price is calculated)
Comparison of Historical Performance
Before delving in to the detailed comparison of the characteristics of mutual funds and ETFs, let’s take a look at how an ETF and mutual fund that track the same index faired during the last year.
For this comparision, we will look at the two Vanguard.com instruments shown below:
- Vanguard Total Stock Market ETF – Symbol VTI
- Expense ratio = 0.07%, minimum to purchase = 1 share = $59
- 1 year return = +41.3%
- 3 year return = – 4.14%
- 5 year return = + 3.64%
- After tax returns still ~0.1% higher than index fund from Vanguard below.
- Vanguard Total Stock Market Mutual Fund – Symbol VTSMX
- Expense ratio = 0.18%, minimum to purchase = $3000
- 1 year return = + 41.2%
- 3 year return = – 4.23%
- 5 year return = + 3.52%
As can be seen from this comparison, the only difference in return between the two instruments appears to be the 0.1% advantage that the ETF carries over the index mutual fund due to having a 0.1% lower expense ratio. Otherwise, the returns appear to be otherwise equal.
Comparison of Characterisitics of ETFs and Mutual Funds (Indexed)
The table below shows a comparison of the different attributes of index ETFs and mutual funds
Note: this table comes to us from page 256 of Jeremy Siegel’s “Stocks for the Long Run” (my investing bible). I would definitely suggest that you click on the link below and pick up a cheap used copy of this very useful book from Amazon.com.
Shares of both ETFs and mutual funds can be bought that are managed in an index fashion. However, ETFs can be bought and sold throughout the trading day, similar to an individual stock.
Generally, ETFs have slightly lower fees than the corresponding index mutual fund. This can be seen in the example above. However, both index mutual funds and ETFs offerred from Vanguard have fees that are much lower than the industry average.
Typically, trading ETFs has involved paying regular brokerage commissions for trading (trading mutual funds of the brand in which you hold your account is free of commissions). However, according to a recent article and the Vanguard fee schedule link below, Vanguard has begun offering commision free ETF trading in-house. Definitely use this to your advantage!
In Siegel’s book, he mentioned that ETFs do not offer dividend reinvestment. However, when I just opened a brokerage/ETF account with Vanguard.com this morning, there was an option that stated that they were now offering dividend reinvestment. Excellent! This is generally preffered for long term investing!
Overall, both index mutual funds and ETFs are very tax efficient. However, ETFs are slightly better in the realm of taxes due to the fact that they generate fewer capital gains than mutual funds (mutual funds generate capital gains when the fund must sell holdings when individual fund investors sell/redeem their shares).
Note: this slightly advantage seen in tax efficiency for ETFs only applies to funds held in taxable accounts.
Before investigating this topic for this post, I tended to shy away from index ETFs because I expected that the ETF would not track its respective index as effectively as an index mutual fund. This was due to my belief that since an ETF can be traded all day long, it would therefore be subject to emotional overreactions (selling and buyin) of investors.
However, in reading more of Siegel’s book on the subject of ETFs, I discovered that ETFs actually track their respective indices very closely because insitutional/large investors can turn in shares of an index for the corresponding ETFs or exchange ETFs for their respective shares. In other words, arbitragers (investors taking advantage of price differentials) cause any price differential to disappear quickly. Thank goodness that those folks on Wall Street take care of that so I don’t have to worry about it!
As I mentioned in the link about beginning to invest with ETFs, ETFs are much better for beginning investors because you only have to buy 1 share in order to get full diversification to the index that the ETF represents.
On the other hand, index mutual funds usually require a minimum investment of $3,000-$10,000 to buy a particular fund. One good thing though is that you do not have to maintain a balance minimum of $3000 in order to keep the fund.
The key takeaway for me is that because Vanguard has started offering 1) dividend reinvestment and 2) commission free ETF trading, I am going to now use both Vanguard ETFs and mutual funds (index, of course). ETFs will fit well in my taxable Vanguard account in situations when I cannot afford the $3000 minimum to purchase a new mutual fund, but still want exposure to a certain asset class in order to balance out my asset allocation %’s.
So, bottom line is that you should probably use both ETFs and mutual funds, keeping the caveats shown below in mind.
You should only use mutual funds (stay away from ETFs) if you know you are subject to easy emotional reactions when the market either goes up or down. Since mutual funds do not fluctuate in price throughout the entire day, you will be less likely to over-react and sell/buy at inappropriate times.
You should only use ETFs (stay away from mutual funds) if you like to use leverage/margins, hedge your investments by selling ETFs short, and enjoy moving quickly in and out of your investments (I do not recommend this approach).
Keep on learning!
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