DR 039: Mutual Funds vs. ETFs–Does it Really Matter?

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Following the conclusion of my 31-Day Money Challenge, I’ve had several people email me about the difference between mutual funds and ETFs (exchange traded funds). A quick review of opinions online may lead some to think ETFs are better than mutual funds. There is a lot of information suggesting, for example, that ETFs are less expensive and more tax efficient.

As we’ll see, there is some truth to this argument (the link is to an article I wrote some time ago about the advantages of ETFs. Still true today, although the advantages are not as clear cut). But for those focusing on low cost index investing, I believe that mutual funds are the better choice (or at least that ETFs offer little if any advantages). For some speciality asset classes, however, ETFs can be a big help.

Let’s dig into the details.

Mutual Funds vs. ETFs

A mutual fund offers an easy way to diversify investments. An investor can buy shares of a stock or bond fund directly from the mutual fund company. The money is then invested in the individual stocks or bonds owned by that fund. For example, with an S&P 500 index fund, money invested is used to buy shares of the companies that make up the S&P 500. By investing in this single fund, an investor gets immediate diversity.

Some key things to keep in mind about mutual funds include:

  • Shares are purchased directly from the mutual fund company, not other investors
  • When you cash out of a mutual fund, you sell your shares back to the mutual fund company
  • The price of a share in a mutual fund is set at the close of each trading day.

On the surface, ETFs are very similar. Like a mutual fund, an ETF typically invests in a broad basket of stocks or bonds. In fact, there are some ETFs that mirror the exact investments of a mutual fund. For example, Vanguard offers an S&P 500 mutual fund (VFIAX) and an S&P 500 ETF (VOO). The underlying investments are the same.

The following screenshots show that these two investing options are identical in terms of cost and performance:

Vanguard VFIAZ vs VOO--Cost

Vanguard VFIAZ vs VOO--Performance

Note that in the second screenshot under the ETF you see both a Market Price and a NAV (Net Asset Value). The NAV is identical to the performance of the mutual fund (except at 3-year where it’s off by one basis point), yet there is slightly more difference with the market price. We’ll come back to this difference briefly when we talk about the premium or discount of ETFs.

While mutual funds and ETFs share many similarities, there are some key differences. Unlike a mutual fund, an ETF trades much like an individual stock. Shares of ETFs are bought and sold through a brokerage, like one of the many online brokers I’ve reviewed here at Dough Roller. There are typically, although not always, trading costs when buying and selling ETFs. Like stocks, the price of an ETF share fluctuates throughout the day when the markets are open. And ETFs are bought and sold between investors, not directly with a mutual fund company.

The Pros and Cons of ETFs

So what’s better, mutual funds or ETFs? Generally, ETFs are considered more tax efficient and less expensive. The keyword there is “generally,” as there are plenty of exceptions as we’ll discuss in a minute. But first, let’s understand why ETFs can result in lower taxes and less cost.

First, let’s focus on taxes. When a mutual fund manager sells securities in the mutual fund, these sales can generate capital gains that flow to the shareholders. Fund managers work hard to minimize taxes by offsetting any gains with losses. But the result can still be a sizable tax hit to shareholders.

One big reason fund managers sell the underlying investments held in a mutual fund is to generate the cash needed to pay shareholders looking to sell their shares. With ETFs, this isn’t an issue. Why? Because shares of ETFs are bought and sold between investors. So the ETF itself doesn’t have to liquidate positions in stocks or bonds to cash out selling shareholders.

Second, ETF expense ratios tend to be lower than comparable mutual funds. ETFs don’t have the operational expenses that often burden mutual funds. They pass the benefit of lower costs onto investors in the form of lower expense ratios. At least that’s the theory.

In practice, I’ve found that the types of mutual funds I invest in are no more expensive than comparable ETFs. For example, I invest in the Vanguard Total Stock Market Index Fund, Admiral shares (VTSAX). Vanguard also offers a comparable ETF (VTI). The expense ratio for both investments is the same–0.05%.

Now the expense ratio is not the only fee you’ll pay for either fund. With mutual funds you also have trading costs, which aren’t part of the expense ratio. With ETFs, you can add brokerage fees, the bid/ask spread, and a premium or discount off of the NAV of the ETF (remember from above that the Market Price can be higher or lower than the NAV. When it’s higher, the ETF is said to sell at a premium; when lower, at a discount). In the case of VTI, the bid/ask spread (the difference between what a buyer pays and a seller receives) is a whopping 1.28% according to Morningstar.

The point is that not all ETFs are in fact less expensive than comparable mutual funds. Forget about what you’ve read in other articles. You need to do you homework to determine whether an ETF is in fact less expensive than a mutual fund alternative. In the case of admiral shares of Vanguard mutual funds, I don’t see a cost advantage to ETFs.

And as for taxes, VTSAX is as efficient as VTI. In fact, VTSAX has a turnover ratio of just 3%, meaning that the fund sells just three precent of its assets annually. With such a small turnover ratio, the fund is not generating a lot of annual capital gains.

One of the best books on ETFs is called The ETF Book, by Rick Ferri. I had the chance to interview Rick about his book several years ago. You can check out that interview here, where we discuss whether investors should buy mutual funds or ETFs.

The Final Analysis

For low cost index investing, mutual funds are ideal for most investors. They are extremely low cost and generally very tax efficient. There’s just no need to venture into ETFs. For certain speciality asset classes, like commodities, ETFs may be the best option. I invest in PowerShares DB Commodity Index Tracking (DBC) to get exposure to commodities, for example. But beyond this, I stick with mutual funds.

What do you think–are mutual funds or ETFs the best option?

Published or Updated: February 21, 2014
About Rob Berger

Rob founded the Dough Roller in 2007. A litigation attorney in the securities industry, he lives in Northern Virginia with his wife, their two teenagers, and the family mascot, a shih tzu named Sophie.

Comments

  1. David S. says:

    When you mention the backdoor Roth IRA also talk about the “backdoor” options for After-Tax Contributions to a 401k plan. Similar to the people that will be using the backdoor Roth IRA you can save up an additional 34.5k (minus the employer match) convert it to a Roth 401k or IRA.

    • Rob Berger says:

      David, that’s a great point. I’ll be sure to include it in the podcast.

  2. Kurt G says:

    Hey Rob, first off, great podcast. I am in the process of catching up and just listened to this episode. I currently use ETFs to fill out my asset allocation because my wife and I do not yet have the funds to invest in the respective index funds (we are just starting out and graduating from school). You mentioning them selling at a premium/discount really took my off guard because I had no knowledge of that prior to hearing your podcast (we are literally just months into our investing lives). I went to Morningstar and looked at the ETFs we own and are using dollar cost averaging to purchase and I have a couple questions: 1. Just to clarify, under the prem/discount column I assume a negative number means the ETF is selling at a discount because the “last price” is less than the “intraday value”. My question is how does this intraday value relate to the NAV? (the fund I am looking at is VWO). 2. Also if I use limit orders to purchase the funds do I still need to consider the bid/ask/spread? I’ve read sever definitions online for the spread but honestly I am still not quite certain about how it works. Any guidance you can give will be greatly appreciated!!

    Thanks
    Kurt

  3. Justin says:

    Hello Rob, I am just about to begin investing and have a few questions about how to determine which fund will allow the best bang for my buck. I want to open up a Roth IRA account with Vanguard and I have only $3,000 to start with. I read your article on the importance of keeping costs low and the importance of developing an asset allocation plan. Since I will have many years to invest before retirement I feel comfortable with a 100% allocation towards stocks right now and will scale more towards bonds as I get older. I am trying to decide between buying the VTTSX target 2060 retirement fund, the VTSMX total stock market index fund, and purchasing ETF funds that mirror the mutual fund investments I like but cannot afford right now. The benefits of purchasing the target retirement fund or selecting ETF stock funds allows me to have a well diversified portfolio. If you were in my shoes just starting off would you invest in a portfolio that has diversified stocks or just purchase the VTSMX total stock market index and wait until you have more than $10,000 to begin allocating funds? How can I determine the additional trading costs of a mutual fund that is not apart of the expense ratio, and how do I determine the “brokerage fees, the bid/ask spread, and a premium or discount” of ETF funds so I can compare the true expenses of ETFs and it’s complementary index fund?

    Aside, I really enjoyed your conversation with Brandon Turner from Bigger Pockets. What is your opinion on using a Roth IRA to save for a downpayment on a house since the withdrawals on contributions and earnings will be tax and penalty free? Where do you feel is the best place to put your money while you save for a downpayment to begin real estate investing? I appreciate your help and look forward to learning more!

    Thanks,
    Justin

    • Rob Berger says:

      Justin, thanks so much for the question. I’ve recorded a podcast that covers how to get started with relatively little money. It will be published next week (Podcast 45). As for the funds you’ve mentioned, I think all of them are reasonable choices. That said, if you want a 100% stock portfolio, then keep in mind that VTTSX allocates 10% to bonds. I think it’s a great option, but it’s not 100% stocks. VTSMX is a great choice for whatever portion of your investments you want allocated to US stocks. As for the ETF version, personally, I’d stick with mutual funds. I think it’s fine to start with a single fund for an initial $3,000 investment, and then add funds as you have more money (an option I discuss in Podcast 45). If you do go with ETFs, which is a perfectly fine option, Vanguard is my first choice. There are no brokerage fees with a Vanguard account when you buy Vanguard ETFs, and they will automatically reinvest your dividends. You will, however, have to pay the bid/ask spread and ETFs may sell ad a premium to NAV. To get this info, just enter the ticker in the Vanguard search box or on Morningstar.

      As for real estate, a Roth IRA can be a good source for a down payment. Just make sure you qualify and don’t exceed the caps. I think the bigger question is when you want to buy. If it’s in the next few years, I’d be hesitant to put that money in the stock market. You could easily end up losing a big chunk of that money if the stock market had a few bad years. Unfortunately, the alternatives aren’t very exciting given our low yield environment. Still, I’d probably stick with a high interest savings account if I planned to buy in say 2 to 3 years. Best of luck.

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