ETF 101: 5 Reasons ETFs Trump Mutual Funds

While I'm on vacation, I've asked a few good bloggers to fill in with a couple new posts each day. This one is from the ETF Expert.

I recently spoke at a seminar in New Orleans. Inevitably, the attendees wanted to know why ETFs are better than mutual funds. After all, don't all 401ks have mutual funds in them? And how come most advisors keep insisting that exchanged-traded funds are for unsuccessful market-timers?

Having spent nearly a decade discussing the virtues of ETFs, I am often troubled by these inquiries. I know that advisors resist ETFs because they're either lazy, uninformed or... worst yet... choosing to sell commission-based mutual funds. (And yes... that is why many advisors don't like to talk about no-commission ETFs. Your advisor won't make money on you!)

As for 401ks, they are mostly controlled by the biggest fund families and largest insurance companies. Since they themselves are not ETF providers, they are less likely to offer them in a plan that they are helping a company administer. (Yet, even 401ks are evolving. More 401ks have begun offering employees ETFs as an alternative within their plans each day.)

By way of review, here are 5 reasons that investors should look to exchange-traded funds for investment success, rather than traditional mutual funds:

1. ETFs Cost Less. Even though you do not receive a bill from mutual fund providers, you are charged a fee through the expense ratio. This is the primary way in which your fund family makes money. The typical mutual fund will run you 1.4%, or $1400 on every $100,000 that you invest. The average ETF has been estimated at approximately 0.36%. Even rounding up to 0.4%... $400 on every $100,000 invested is a lot less expensive than $1400.

2. ETFs Track Indexes...And Indexing Beats Actively Managed Mutual Funds. It may represent Wall Street's dirtiest secret, but fund managers do not beat pre-established indexes over significant lengths of time. Over any 10-year period studied, the overwhelming majority of actively managed mutual funds with overcompensated stock-picking gurus cannot keep up with the benchmarks (a.k.a. indexes) that they are paid to beat. When a few managers do outperform, the stock picker has often taken excessive risks in one segment of the economy (e.g., technology, energy, etc.). Yet given time, those big risks come back to bite. In short, ETFs track indexes, and indexing are your preferred road to success.

3. Pricing. Traditional mutual funds are priced at the end of the day. you have no control over the price you purchase at and, more importantly the price you may wish to sell at. In contrast, like individual stocks, ETFs makes it possible for you to choose the price point you wish to buy at. And, should you need to sell to protect your portfolio from sharp downturns, you have control over the price you wish to sell at as well.

4. Tax Efficiency. Traditional mutual funds buy and sell stocks. And many active managers have turnover rates... rates of turning over a portfolio in a year... of 100%. That's a lot of buying and selling of stock picks. The mutual fund structure. passes along capital gains form the buying and selling activity to the fund shareholder. You may not have any personal gains from being a fund shareholder, but come year-end, you are likely to experience a distribution that you must pay tax on... even when you are simply holding the fund! ETFs have next-to-no turnover because indexes rarely change. The low turnover of ETFs leads limit capital gains distributions and, due to a unique structure for ETFs, even rebalanced indexes do not necessarily have to buy and sell. In short, if you wish to keep the money you make, rather than pay taxes, ETFs win hands down!

5. Transparency. When you buy a mutual fund, what do you really know about it? You see a few stars from a rating group like Morningstar. You see a number of calendar year percentage gains. Do you really know what the fund manager invests in? You may get as description of the top 10 holdings in  a previous 3 month period, but you are essentially, guessing. In contrast, an exchange-traded fund (ETF) represents a specific index. You know exactly the stocks in that index and exactly the weight of each stock in the index. That transparency gives you the confidence to know what you are investing in...precisely.

Comments

[Susan]

On #1, since most mutual funds price the expense ratio directly into the fund, it doesn't matter if you buy the fund by ETF or directly through the fund company. For example, the Vanguard 500 index fund has a 0.18% expense ratio built into the share price. As a bonus, if you buy directly through Vanguard, you have not brokerage fee for buying and selling.

#2, you can also buy a mutual fund that tracks an index as well.

#3, a benefit of mutual funds is that they encourage buy and hold, and keep you from making stupid emotional trading decisions.

#4 and #5, see #2

[Kurt]

"As a bonus, if you buy directly through Vanguard, you have not brokerage fee for buying and selling."

We have a winner! This is the most important thing to keep in mind. If you dribble your money into the market either to dollar cost average (boooo) or as you earn it (yay!), many little transactions at $10 a trade (plus the bid ask spread, don't forget that) really adds up. A mutual fund doesn't have these issues (assuming no load, etc, which I would assume most people try to do if they are in a fee minimizing frame of mind).

[Kurt]

"As a bonus, if you buy directly through Vanguard, you have not brokerage fee for buying and selling."

We have a winner! This is the most important thing to keep in mind. If you dribble your money into the market either to dollar cost average (boooo) or as you earn it (yay!), many little transactions at $10 a trade (plus the bid ask spread, don't forget that) really adds up. A mutual fund doesn't have these issues (assuming no load, etc, which I would assume most people try to do if they are in a fee minimizing frame of mind).

[Matt]

I'm going to ditto on some of the comments above. It seems like the post spends a lot of time comparing apples to oranges and beating up a straw man.

If you're going to compare index ETFs to the average actively traded mutual fund, OF COURSE the ETF will look better! Duh!

Try comparing instead to what a smart 401k investor does with his or her account at Vanguard or Fidelity: buy low cost, low turnover, no-load index mutual funds every 2 weeks. These kinds of mutual funds are the clear winners because there are no trading commissions.

Here's my favorite quote from the post: "And how come most advisors keep insisting that exchanged-traded funds are for unsuccessful market-timers?" Now juxtapose that with point #3. So which is it? Are ETFs for market-timers or not? (Hint: yes, they are.)

[Rick]

For those who are complaining about transaction fees, you should try Zecco. It offers up to 40 free trades per month. Yes, it's a bare-bones interface, and it doesn't offer as much research information as other brokerages, but it's free.

You guys are right that for a buy-and-hold strategy, being able to buy an ETF at mid-day prices is somewhat of a moot point. Nevertheless, ETFs still have a significant advantage over mutual funds. Consider the Vanguard Total Stock Market Fund (VTSMX). It has an expense ratio of 0.19%. Now consider the equivalent ETF (VTI). VTI has an expense ratio of just 0.07%. If you invest with Zecco and pay no transaction costs, over time with any significant amount of money you'll save hundreds or even thousands of dollars by using the ETF rather than the mutual fund.

[Kevin]

Don't forget mutual funds let you reinvest dividends for free, ETFs do not.

[MrAtoZ]

When my wife wanted to role over a 401k from a former employer, putting it into ETFs (through a formula from TD Ameritrade for aggressive long-term investments) made more sense than purchasing mutual funds. I think anyone moving substantial lumps of money around, from IRA to IRA, or rolling over 401Ks, ought to seriously consider ETFs.
OTH, if you are regularly inveseting DCA-style, ETFs make less sense because of the transaction costs. So, like many things in life, the comparison really depends on the frequency of your transactions. But for buy and hold investors who are periodically moving chunks of equity around, ETFs make a lot of sense.

[Zook]

Rick....At sharebuilder, I have ETF's and they do allow dividends to be reinvested for no fee and no hassle. I'm sure others have the same deal.

If you hold mutual funds inside tax advantaged accounts, it wont matter when they give you back your gains at the end of the year because it's all gravy anyways and taxes have been paid already...

ETF's were created for a reason...I diabolical one. The positives, on a large scale, favor "the market" over the investor or "the market" wouldn't have come up with this idea to begin with.

ETF's DO allow the young investor with an account at Zecco or Sharebuilder, to begin investing with small amounts of money, whereas if you went to Vanguard or Fidelity, you need large upfront amounts to get started. I do think there is something to be said for the 23-year old with a Roth IRA to have $250 in VTI and feel like the account is doing something over having $250 sitting in lieu in the money market account as you build up funds.

[Free]

I agree

[Uninformed People Make Me Sad]

ETFs are still cheaper, period, when comparing apples to apples.

If you invest in a .19% fee mutual fund at Vanguard, then guess what, you'll pay .19% per annum, period.

If you invest in a Vanguard ETF (tracking the same index) with a fee of .07%, then, last time I checked, you'll pay less than half of the fee.

So, you pay 4.95, 7.00, or 9.99 for a brokers fee to buy an index ETF + .07% or you pay .19%. Get a calculator, plug in that you invest $2000 a year in one or the other, figure it out over a ten year and time-frame, assuming a moderate and equal rate of return and compare. Its not even close.

ETFs get people in trouble with one thing... the broker fee. If you invest lump sum ($2000 a year, -$7 commission) then you'll ALWAYS come out ahead buying the ETF over the index mutual fund. IF you want to invest $200 a month into an investment, then brokers fees, even $4 at Sharebuilder for instance, will destroy the savings and end up costing more; even over a longer period.

Bottom-line: If you are dollar cost averaging, investing each month (or every two weeks, or some such thing) then a low cost, index mutual fund is the way to go (buying the fund though the fund company or via a no transaction fee arrangement); otherwise, once a year, twice or year, or (depending on the fee spread and commission) even quarterly investment in an index ETF will save you money.

Its not an opinion. Its math.

[thomas]

I definitely need to look into ETFs more. Thanks for the valuable info.

[Kurt]

"Its not an opinion. Its math."
It's also not correct English.

[Ryan]

Uninformed People Make Me Sad:

As stated before, the .18% "fee" that Vanguard charges is priced directly into the share price, so whether you buy it through Vanguard directly or through an ETF, you still pay the fee since you are buying at Vanguard's share prices.