Comparing the Performance and Tax Advantages of Index Mutual Funds vs. Index ETFs

A reader e-mailed me an interesting article about index funds from today’s Wall Street Journal entitled A Close Race, a Surprising Finish. It’s only available for 7 days, after that a subscription is required.

The basic idea was to try and compare after-tax returns of index mutual funds and index ETFs, due to the often-touted tax-advantages of ETFs. The article summarized these theoretical benefits well:

The tax-related advantages of ETFs stem from their unique structure. ETFs are created when securities brokerages or specialists assemble baskets of stocks that match an ETF’s underlying index and exchange them with the fund for ETF shares that the brokerages can either hold or sell to small investors. These ETF shares can be bought and sold any number of times without the underlying stocks they represent being touched. When the brokerages opt to take ETF shares off the market, the fund hands over stock, rather than cash. This allows the ETFs to avoid selling their underlying stocks to accommodate investor traffic.

(This explains why many mutual funds have purchase or redemption fees to discourage active trading, while ETFs can be bought and sold all day long.)

For this study, commission costs for both were assumed to be zero. So who won?

Big, low-cost index funds from Boston-based Fidelity Investments and Vanguard Group Inc., Malvern, Pa., outperformed the ETFs in most of the comparisons we set up. For the 40 time periods studied, the mutual funds prevailed in 34 — including a sweep of the one-, three-, and 10-year after-tax categories.

Why is this?

The lesson for small investors: Whatever structural differences ETFs may have in the way of tax advantages, other factors — such as a fund’s expense ratio and management philosophy — can be equally important in determining performance in the competitive index-tracking business.

ETF tax advantages pertain, by and large, to capital gains, not dividend distributions. And, as noted, ETFs almost never sell their funds’ underlying securities, so capital-gains taxes are rare… But S&P-500 index mutual funds are pretty efficient, too. They don’t trade holdings as often as mutual funds run by stock pickers, so they rarely distribute capital gains either.

The lack of significant tax advantages for index ETFs is especially true in the case of Vanguard ETFs and mutual fund equivalents, as they are just different share classes of the same investment holding. I believe Vanguard does this so they can use the ETF “side” to keep their taxable events to a minimum, benefiting the mutual fund costumers as well. Here, the only difference in raw performance should be due to the different expense ratios.

Added
Management philosophy? Why does this matter in an index fund? Well, this is another area that may surprise some – it takes skill to manage an index fund!! A good index fund manager can eek out a few more basis points of return. From the article:

In addition, tactical moves by index-fund managers can boost results. While an index fund should, in theory, trail its benchmark by at least the amount of its expense ratio, fund managers can reduce at least some of the cost through techniques such as lending out the fund’s underlying stocks for payments, and buying stocks ahead of anticipated additions to their index.

From Vanguard:

Not all index fund managers have equal skill in tracking target benchmarks. Skilled managers may, for example, be able to minimize the transaction costs associated with managing the portfolio.

Vanguard and Fidelity both seem to be adept managing index funds well. Here is an article from Efficient Frontier (see, I told you it has some good stuff.) that discusses this further, calling it transactional skill, as opposed to stock selection skill.

Summary
This article is intended for people who have already decided that index funds are best for them, and they are just wondering how to best implement it. As the title says, it was a close race and there was no runaway winner. This is important! It’s unlikely you’ll end up in the poor house due to picking over the other.

Now, if you do want to optimize, the article indicates that while low expense ratios, structural tax advantages, and good management are all important, any one by itself won’t guarantee the absolute best performance. You have to find the best combination of all three, as well as consider things like fees, commissions, and minimum balance requirements.

Comments

  1. Heather says:

    Thanks so much for that article. I’ve been struggling with trying to understand ETFs. My (no longer) secret goal for our “fun money” is to buy an etf or mutual fund in an industry that is un-correlated to our current jobs, as a hedge against it (the mister works on fairly specialized stuff.)

  2. Jonathan- thanks for the article, its really great. Is it just me, or do Fidelity’s index fund offerings look like the best pickings?

    I am still having trouble understanding why lower expense ratio, more tax advantaged funds are worse performing than their index fund cousins. The article says things like “management philosophy” but I am still very confused as to what that means.

  3. I think the article is a little sloppy. As an individual investor, I can ignore the institutional class funds. That shifts several ‘winnings’ to the ETFs. The take-away message to me seems to be that expense-ratio is king–whatever the investment vehicle.

    > “It’s not about the ETF structure. It’s the management,” says Jim Wiandt, editor of the Journal of Indexes…

    I don’t know why this should be relevant for an index fund, and it makes me suspect ulterior motives. The management should be tracking the index, and if they can’t do that, they should change professions. My opinion is:

    “It’s not about the structure, it’s about the fees.” If ETFs have lower fees, then great. If index funds do, that’s great, too.

  4. I have added more information about “indexing skill” and what is meant by good management to the original post, as I felt it was important to clarify. Thanks for asking about it.

  5. smurfett says:

    I have some money in ETFs and was thinking about putting some more in but I did a bit more research first and decided against it.

    One article I read basically said that if you’re doing automatic investments (like a little bit every month),then it’s actually better for you to just go w/ mutual funds; esp if the funds underneath are the same funds. The reason is because of the commission you will be charged monthly. It can add up to quite a bit. but if you have a big chunk of money, ETFs aren’t bad at all.

  6. Stephen says:

    I just wanted to point out that the idea that: “with commissions, ETFs lose out” is common – and wrong.

    It only works that way IF you have an account WITH the mutual fund company.

    If, for instance, you’re buying stocks/funds within an IRA that you have at, for instance, Etrade or Ameritrade, you’re going to pay more for a fund transaction than a stock (ETF) transaction. Ameritrade raised their fund commissions to $50 without advertising it last year or the year before.

    A lot of people base praise for funds or complaints about ETFs on two assumptions:

    1. If you have ETFs, you’re trading in and out (racking up commissions), while if you have index funds you’re buying and holding. This is the basis of most of John Bogle’s complaints about ETFs.

    2. If you have index funds, you only buy index funds that are run by the company running your investment account. Commentators/writers seem to completely ignore the fact that mutual fund commissions have really gone up the last 5 years or so.

    That all being said – NOW you compare expense ratios, past performance, etc. Make your decision on the statistics.

  7. Yeah, with commissions, ETFs lose out, but I was planning on zecco’ing my ETFs, leaving me with the difficult choice of
    1. Vanguard Index Funds(no min. fees but higher expense ratios)
    2. ETFs (no commissions, lower expense ratios but no “indexing skill” benefits)
    3. Fidelity Index Funds (lower expense ratios, but still has minimum fees for under $10,000- & I would incur opportunity costs to save money “out of the market” to meet the 10K minimums)

    Anyone have any thoughts?

  8. On a very very simplistic level, I think the easiest path would be to buy index funds from Vanguard until one has the assets to make a lower expense ratio savings a significant value.

    If someone wants to do ETFs, that would be fine, but it would probably only work out well with a broker that offers free trades. This would allow someone to for example, buy smaller amounts of several different index funds if that was their preference.

    I have both Fidelity and Vanguard index funds, but Fidelity has a smaller selection of index funds and the higher $10k minimums. With Vanguard doing away with its low balance fees recently, I think Vanguard keeps its edge in my book.

  9. I agree with Meme regarding the sloppiness. Let’s look at the numbers they provided. The international funds outperformed the ETF listed and amazingly have lower expense ratios. The total stock market funds and ETFs track slightly different indexes, so the one that happened to track the best performing index (which happened to be a fund), amazingly performed the best. High minimum (read $100K)admiral/advantage funds with lower expense ratios amazingly outperform everything. Did anyone else notice that the author did not include 10yr returns in the S&P comparison table, but does acknowledge in the text that “Over 10 years, Investor shares of the Vanguard fund edged SPDR, although by only the thinnest of margins: 7.64% to 7.63%”. Perhaps a 0.01% difference in return over 10yrs wasn’t as exciting as the worst-case scenario of 0.09% in the 5yr period. Hmm, why would you use short-term fluctuations in your 30-yr, 250K example when longer-term figures were available?

    And finally while using the ETF NAV returns is great for comparing management vs. funds, it’s a bit irresponsible to then use these numbers to make 30yr extrapolations of hypothetical performance without considering actual market returns. Considering that the 10-yr market return on SPY, for instance, is 0.05% higher than its NAV, perhaps the author’s assertion is that one 0.05% deviation is statistically significant while another is not.

    It seems to me that the author did alot of research hoping for a smoking gun, and in the end found out that fees, not fund vs. ETF, really are what effects return. Not exactly the “surprising finish” we were proimised in the article’s title. I always wondered if paying for a subscription to the WSJ online would be worth it. Now I know…

  10. “Commentators/writers seem to completely ignore the fact that mutual fund commissions have really gone up the last 5 years or so.”

    I think that they ignore this fact because it is relatively easy to sign up for an account directly at many institutions and trade mutual fund with no fees – Vanguard, T Rowe Price, Fidelity, TIAA-CREF, Bridgeway, and others. Yes, there may be more paperwork and hassle, but it’s a very accessible option to the public and has been around for years.

    Now there are also free stock trades, and as that becomes more accessible to everyone, I think the talk about stock commissions will also change. Instead of “assuming” a $10 trade, maybe it’s $5 or even free.

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