Today’s investor has more options than ever when it comes to where to put your money. These choices can be overwhelming, so today we will focus on a basic question often put before an investor. Should I buy an ETF or a mutual fund?
I want to quickly point out that you must first decide what type of investment you want to buy. I hear people say funny things all the time like, “Stocks have rebounded, but mutual funds are still lagging.” Comments like these do not make sense because there are thousands of different types of ETF’s and mutual funds that gain access to all corners of the market. The underlying securities of these funds drive a fund’s risk profile.
As an example, let’s assume we want to gain access to the US total stock market. We have narrowed the choices down to two offerings from Vanguard. Either the mutual fund VTSSX or the ETF VTI. These two investments are actually different share classes of the same overall fund, so the underlying investment is the same. The only difference is the investment vehicle.
I will compare each investment in these areas:
3. Tax efficiency
The most obvious difference between mutual funds and ETF’s is how they are purchased. To buy shares of the mutual fund VTSSX you would purchase shares directly from Vanguard or through a brokerage account. You are able to purchase fractions of a share making it possible to buy exactly how much you want. You can place an order anytime during market hours, but the shares are only priced once per day at the close of the market. Basically the price you pay is the total assets of the fund, minus its liabilities, divided by the total number of shares outstanding. This is commonly referred to as the fund’s NAV or net asset value.
Unless you are a large institutional investor you must buy your shares of the ETF VTI in the secondary market. This creates a more complicated situation for an investor if you want to get a fair price. With ETF’s it is possible to pay a premium or discount to the fund’s NAV. On Vanguards website you can see the how often this happens. In the 4th quarter of 2012 it traded at a higher price than its NAV 51 days and below its NAV 13 days. The greatest premium was 0.08% and the greatest discount was -0.03%. VTI trades millions of shares a day, so it is a pretty efficient market. Less liquid ETF’s can have much larger gaps between its NAV and the price you pay in the market. To be sure you are getting a fair price you should check what the actual NAV is before you place your order for VTI. To do this you can go to Yahoo Finance and type in ^VTI-IV. This will give you the Intraday Indicative Value which is pretty similar to its NAV. This value is updated every 15 seconds. ETF’s can trade much higher than its underlying NAV, so it is important to check the NAV before purchasing.
Although there is increased complexity in buying an ETF, you do have the flexibility of being able to trade them throughout the day. This may seem like a good thing since you are not forced to receive the closing price. However, this may lead you down an unproductive path. Studies show that the more trades you make in your portfolio, the lower your returns. One study looked at the dollar-weighted returns of ETF’s and mutual funds and it indicates that the average investor who owned an ETF like VTI had a return almost 2% less per year than the average investor who owned a mutual fund like VTSSX. It is no surprise investors were attracted to the increased trading flexibility, and, as a result, were likely trading in an undisciplined manner by trying to “time the market.”
When it comes to trading I will give the advantage to VTSSX.
Since both VTI and VTSSX are different share classes of the same fund, they share many costs. While these costs will not affect our decision on which to buy in this example, I will briefly go over them so we have a better understanding of how they work.
Both funds must pay various transaction costs coming from three main sources; brokerage commissions, bid/ask spreads and market impact costs. Brokerage commissions are the fees that the fund pays to trade the stocks in the account, similar to the brokerage fees you might pay in your own brokerage account. For example, in 2011 VTSSX paid $4,704,000 in brokerage fees. This information can be found on the Statement of Additional Information issued by the fund annually. We will delve deeper into bid/ask spreads later, but they are basically a cost associated with buying stocks in the market. A fund buying mostly large cap stocks will have less bid/ask spread costs than a fund trading micro caps because the spreads are wider in micro caps. Market impact costs occur when you want to buy a large block of stock all at once. It is possible to move the market for a stock by placing a large buy order, only to have the price readjust after your purchase. All of these costs increase with a fund’s turnover rate (rate at which positions in the fund change). For the year 2012, VTSSX had a turnover rate of only 3.2%, a very low number. If you see a fund with a high turnover rate, then check these costs and compare them to similar funds.
Other cost besides transaction costs are cash drag and other hidden costs. Cash drag reduces the return of a fund because it must keep a certain amount of cash around to pay redemptions. Active funds might keep cash around to try to take advantages of opportunities. Other hidden costs include such things as rent, travel expenses and employee salaries.
The above costs were the same for both the ETF and mutual fund, so now we will talk about the costs that are different. First, the expense ratio – it is surprisingly the same for both investments at 0.06%. It is almost always the case that the expense ratio of the ETF version is lower than the mutual fund version. The expense ratio represents the ongoing cost to operate the fund and includes the management fee and the administrative costs. The expense ratio is deducted directly from the NAV of the fund thus reducing returns for investors.
Mutual funds can contain other types of fees such as sales fees, 12b-1 fees and purchase and redemption fees. I won’t go into detail on each one since VTSSX does not charge them, but many funds do. You should check the prospectus of each mutual fund you consider buying to fully understand what fees you will have to pay.
ETF’s do not charge the fees above, but they do have an expense that mutual funds don’t: the bid/ask spread. We talked above how the fund has to pay these fees, but with ETF’s the investor also must pay these fees when buying them on the secondary market. As an example, let’s assume the bid/ask spread or VTI is $80.09/$80.10. This means that the most eager buyer is willing to buy VTI for $80.09 and the most eager seller is willing to sell it for $80.10. In this case the spread is only $0.01, a very low number signaling a liquid market for VTI shares. Let’s say for the sake of argument the bid/ask spread is $80/$90. This would be a very illiquid ETF. I put in a market buy order and I buy the stock for $90, the most eager seller’s price. A month later the price and spread has not moved at all, but I want to sell my shares now. I put in a market sell order and I sell it for $80, the most eager buyer’s price. Even though the underlying price of the securities has not changed I lost $10. You should consider the liquidity of the ETF before purchasing.
Lastly, an important cost to consider is brokerage commission, which depends on where you are holding your money. If you are purchasing your mutual fund shares directly from Vanguard, then they will not charge you a commission. If you have your money at a brokerage account, then you may have to pay a fee to buy a Vanguard mutual fund. Most brokerage accounts will charge a commission to trade an ETF ranging anywhere from $7 to $20. Lower is not always better since execution is just as important as price. You should do periodic reviews of your chosen brokerage house to make sure they are executing well on their trades. If you have a brokerage account at Vanguard they waive the commission if you buy Vanguard ETF’s.
While there are a multitude of fees to deal with I would call this a tie. Costs are heavily influenced by how each security is purchased.
ETF’s are structured in such a way that enables them to be more tax efficient. Smaller investors must purchase ETF shares on the secondary market, but large institutional investors can purchase large blocks of shares (normally around 50,000) directly from the fund company known as creation units. Normally these shares are purchased and sold using baskets of stocks fairly similar to those comprising the ETF.
When a mutual fund buys a stock then subsequently sells it, a capital gain or loss is created. This capital gain, combined with all the other ones throughout the year, must be eventually passed through to the investors of the funds. It is not uncommon to see capital gain distributions from mutual funds at the end of the year reflecting your share.
This is where ETF’s gain their advantage. As institutional investors trade in creation units for stocks, the ETF’s are able to give them the ones with the lowest purchase price (representing the largest potential capital gain). When the remaining stocks are sold, the amount of capital gain is lower and is often cancelled out by capital losses taken throughout the year. In fact, most ETF’s don’t have to distribute capital gains after their first few years of existence. Dividends and interest income are not affected by trading creation units, so REITs and Bonds should still be held in tax-free accounts if possible.
In our example, however, VTI is a share class to an existing fund. Therefore, all share classes benefit from the creation units being traded for stocks. VTI and VTSSX end up having the same tax efficiency and once again it is a tie.
Many mutual fund families offer tax-managed mutual funds that will normally do an even better job of keeping tax costs low.
A Quick Note on Notes
NEVER buy an ETN or exchange traded notes. Someday I will post something more in-depth about them, but the gist of the argument is you are taking credit risk that you are not compensated for. For now, just say no to ETN’s.