ETFs vs. Index Mutual Funds, Revisited

We’ve talked in the past about the merits of index funds vs. ETFs. Today I wanted to highlight the views of one my favorite financial authors, William Bernstein.

In his book “The Intelligent Asset Allocator, ” Bernstein said the following about ETFs in general, and SPDRs (i.e., ETFs that track the S&P 500) in particular:

“They have both advantages and disadvantages relative to a conventional index fund. On the plus side, they can be traded throughout the day, as opposed to a conventional fund, which is priced only at the end of the trading day. SPDRs do not generate appreciable capital gains and are thus slightly more tax-efficient than conventional S&P index funds. On the other hand, the purchase and sale of an ETF incurs both commissions and spreads, and so is slightly more expensive to own. Also, ETFs reinvest dividends only quarterly, and thus will suffer a slight performance drag relative to a conventional fund, which continuously reinvests its dividends. On the whole, unless you are an active trader, ETFs hold no real advantage over a conventional index fund.”

Well said. One thing that I would add is that, while ETFs are subject to brokerage commissions, they typically have lower expense ratios, and thus have marginally lower ongoing costs to own.

As for us, all of our stock and bond investments are in an index fund of some sort. We’ve considered ETFs, but we got started back before they were widely available, and have decided to stay the course.

According to Vanguard, you can convert index fund shares into ETFs without incurring taxes, even if you do this in a taxable account. We haven’t bothered to do this, in part because we now qualify for Admiral shares (which have a very low expense ratio) in several accounts, and would thus gain very little by switching to ETFs.

8 Responses to “ETFs vs. Index Mutual Funds, Revisited”

  1. Anonymous

    Any thoughts on the different styles/weightings of ETFs? I don’t believe index funds offer the various differences but I could be wrong. Looking forward to hearing your thoughts.

  2. Anonymous

    I’m more a buy and holder, but I prefer ETFs because I can buy them without a brokerage commission, and I make up for the spreads by holding them a long time. Here’s one person’s view of the ETF advantage over index funds: link

  3. Anonymous

    The basic rule for ETF vs. Index Mutual Fund (IMF) goes like this:

    Active trader = ETF
    Passive investor = ETF or IMF
    Passive investor w/o future purchases = ETF
    Passive investor w/future purchase = IMF

    Part of this depends upon the amount of the ongoing investments, but for most that are doing $50, $100, or even $200 each month or pay period, mutual funds offer cost savings over ETFs.

    To Steve’s point about being able to ‘react’ to major events, I’d say that’s a personal preference. The overwhelming majority of academic research favors Nickel’s more passive strategy and I would argue that changes in one’s personal situation are far more relevant to shifts in investment allocations than any market forces.

    Active traders love ETFs, passive investors can love them too…if it saves them money.

    @Manshu – while you could buy one share of an ETF and avoid an investment minimum in some funds, it’s also important to consider the cost of the trade to buy a single share. I’ve been very impressed with the efforts of Zecco, TradeKing, and Sharebuilder to deliver ETFs and other securities at a very low cost. However, they’re still not zero.

    In addition, there are plenty of quality mutual funds both actively and passively managed that waive minimums in exchange for systematic contributions of $25 to $100 per quarter.

    @Nickel – good topic, and love the Bernstein reference. Oh, and enjoy the Admiral share class…it’s nice.

  4. Anonymous

    You can buy just one stock of an ETF, while MFs usually have a minimum investment required. That doesn’t matter to a lot of people, but others with little to spare are influenced by that factor as well.

  5. Anonymous

    This is a major issue w/me…..

    I think you have to use the proper tool given your own situation. There is nothing inherently bad about actively managed funds.

    Are they more expensive? Yes.

    Do they outperform ETF’s? Many do.

    For a long-term buy and hold (something I’m not a fan of) the ETF is pretty attractive.

    For someone who is more active (like myself), it doesn’t matter. All I care about is return and I make my decisions based on that.

  6. Steve: I don’t like incurring brokerage costs every time I want to make an incremental investment. For us (and for our investing style — buy and hold with monthly purchases), that expense would outweigh the advantages. Yes, we could move all of our investments to a “commission-free” broker, but I don’t want the hassle. A possible workaround that we’ve considered has been to accrue shares through the mutual fund version on an ongoing basis, and then convert to the ETF version periodically to minimize the number of transactions.

    P.S. You’re correct on the title — I used “index fund” as a shorthand for index mutual fund, but since the “F” in ETF stands for fund, it’s kind of confusing. I’ll correct it.

  7. Anonymous

    Don’t confuse the difference between ETFs and an index *mutual* fund. At the core, an ETF is an index-based security. The title makes it sound like an ETF is not based on an index, which is misleading.

    I’m convinced an ETF is always better than the mutual fund. They give the investor more control. If you have self-control, you can do everything through an ETF as you can in a mutual fund, but and sell only at the end of the day if you want to mimic the mutual fund.

    Here’s the one thing that convinces me of always using an ETF over a fund -> if some major event happens in the middle of a day, you can react. When September 11 happened, you could have immediately sold off your portfolio rather than have to wait until the end of the day and been last in line.

    Also, I like seeing exactly what I’m buying at and the total costs, etc, which you can do in a brokerage. With a mutual fund you usually have to wait until the next day to see your transaction report and the result.

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