Index Mutual Funds or Index ETFs: Which Is Better?

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Ever since exchange-traded funds became popular, many index fund investors have taken notice. Should we try to take advantage of the often-lower expense ratios? Can we overcome the commissions from trading? For example, both of these track the S&P 500 index:

IVV – iShares ETF, expense ratio of 0.10%
VFINX – Vanguard Mutual Fund, expense ratio of 0.18%

I just ran across this article at IndexUniverse.com, which compares the performance of mutual funds vs. ETFs for various indexes.

The general conclusion was that the main ETF for an index outperforms the average mutual fund tracking the same index. However, if you choose the Vanguard fund version, you will get very similar or sometimes even better performance due to their superior index management.

These conclusions were based on plain total returns. This is disappointing, as the article even points out in the beginning that two other factors are very important: commission costs and tax-efficiency differences.

Commission costs
Let’s go back to IVV vs. VFINX. IVV has a 5-year annualized performance of 5.99% vs. VFINX’s 5.97%, a difference of 0.02%. 0.02% of $10,000 is only $2. Two bucks! You make one trade, and the edge is gone.

But, you say, 0.02% of $100,000 is $20. Sure, but If you have $100,000 you can get the Admiral shares of VFINX, which will give you a 0.09% expense ratio and make Vanguard a clear winner.

Tax-efficiency
ETFs have a structural advantage over mutual funds in the way they can manage the cost-basis of shares. But the article neglected to compare the after-tax returns of any of the ETF/mutual fund pairs. If you’re in a tax-advantaged account this doesn’t matter, but it would have been nice to have it as part of the discussion.

In the end, as long as you are not using a poorly-managed and expensive index fund (many of these lurk in 401ks), I think you can’t go too wrong either way. I’m still happy with my Vanguard mutual fund portfolio.

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Comments

  1. Colin Miles says:

    It is all about expenses when you are dealing with indexed securities.

    If I have a client who has a large lump sum, enough to purchase a round lot of cubes or spiders and doesn’t plan on putting small, incremental amounts either monthly or quarterly, then the ETF is the way to go. One commission, one large purchase of shares.

    IF, however, they are just starting their portfolio with a small amount of money and want to add monthly amounts, the Vanguard mutual fund is the best option.

    Just think if they had to pay a commission off each small purchase of the ETF? The expenses would be astronomical compared to the mutual fund.

  2. Agreed.

    My additional takeaway is that there might be such thing as indexing skill, in addition to expenses.

  3. Can anyone explain the ETF Management fee?

    I mean, If I can sell ETF just like stock whenever I wish, then will they charge a Management fee in pro-rata base to my equity account or what?

  4. As I understand it, expenses are taken out daily from the ETF’s NAV (net asset value). This in turn affects the share price. ETFs can trade above or below NAV, but usually by only a very small margin for index ETFs.

    So it’s all included in the share price. You won’t see a separate fee charged in your brokerage account, no.

  5. Also mutual funds typically have minimum investment amount and min holding period or there will be extra fees

  6. and btw FSMKX (fidelity s&p index funds) only has 0.1% expense ratio which matches the IVV

  7. If you buy the ETF’s on commission free brokers as Zecco.com you wouldn’t have to pay any commission as long as you have $2000 in the account.I think this could be one way where the ETF’s could beat the mutual funds as the commissions don’t eat into your returns.

  8. If Free commissions do become the norm, then some of these arguments go out the window.

    Some negatives about ETFs:
    1. Unless you are dealing with large sums of money, the commissions kill you.

    2. Rebalancing – ETFs encourage you NOT to rebalance since you pay a big commission for small changes. Most people’s accounts do have commissions, so Mutual Funds (which usually let you rebalance for free) are a much better choice.

    3. Dollar Cost Averaging – ETFs are expensive to dollar cost average into due to commissions. If you use a service like Sharebuilder.com you can reduce these fees. (but when you go to sell, if you sell through sharebuilder your commisions will be high)

    Advantages of ETFs:

    1. Option Writing – In a boring market you can write out of the money call options on your shares and generate income. This can be a significant advantage for people who own hundreds of shares.

    2. You can short ETFs

    3. You can buy ETF options as hedges regardless of whether you own the ETF or Mutual Fund – so that is not a valid agument for preferrring one over the other. But it is an argument that supports that the existance of ETFs is a good thing.

  9. Independent George says:

    Most Vanguard index funds charge a $10 maintinance fee for account balances below $10,000 (the REIT fund – VGSIX – has a min. balance of $5,000; more on that below). My plan was to start with ETFs in my IRA, then move them over to Index Mutual Funds once I had built up a sufficient balance to minimize fees. I’ve been buying ETFs using lump-sum, maximum contributions to my Ameritrade Roth IRA since 2002; in January, I’ll be transferring the whole lot to a Vanguard account. Even with the $25 fee to close the Ameritrade account, I still come out slightly ahead.

    I continued to stick with ETFs in order to eventually add VGSIX without either paying the maintinance fee, or allowing the REIT to take up more than 20% of my total holdings. Starting in 2008, I’ll DCA my contributions, gradually diluting the REIT until it falls to 10% of total holdings.

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