Should investors buy ETFs or mutual funds? The answer is, it depends. It depends on the priorities an investor has. There are three factors driving the decision: costs, custody, and convenience. The weight that each person places on each of these three factors will determine whether they will be happier with ETFs or mutual funds.
The simplest way to look at costs, custody and convenience is to analyze Vanguard fund choices. They offer both ETFs and mutual fund shares of the same fund.
ETF and mutual fund costs
ETF and mutual fund costs come in five varieties:
1. Expense ratio: Both the mutual fund and ETF have management fees and administrative expenses. Take, for example, the Vanguard Total Stock Market fund. Costs for investor class shares (VTSMX) are 0.19%, Admiral shares (VTSAX) are 0.09, and ETF shares (VTI) are 0.07%. Just using expense ratios makes the choice for ETFs easy. However, overall costs are more complex than expense ratios alone.
2. Commissions: When you buy ETFs through a broker, such as Vanguard Brokerage Service (VBS) or Charles Schwab, you will pay a commission to buy Vanguard funds. At a majority of brokerage firms the commission to buy mutual funds is higher than buying the dollar equivalent of ETF shares. There are no commissions if you buy Vanguard mutual funds directly through Vanguard.
3. Trading Spreads: A trading spread exists for any security traded on an exchange. That is one way brokerage firms and traders hedge their risks and make money. With ETFs, the buy (ask) and sell (bid) spread is the difference between what you pay and the true net asset value (“NAV”) of the fund at the time you bought it. The NAV is only known at the end of the trading day. During the day an estimate of NAV is published every 15 seconds. That estimate is known as the Intraday Indicated Value (IIV). The spread around the IIV can be a penny or two per share, or it can be 25 cents per share depending on when you buy, the liquidity of the underlying securities, and the confidence that the IIV is close to the NAV (which can be a problem with thinly traded US securities and foreign stocks). Only ETFs trade on an exchange, so this expense does not affect mutual fund buyers.
4. Redemption fees: Some mutual funds have redemption fees if they are not held for a certain period of time. For example, Vanguard REIT mutual fund shares have a redemption fee of 1% if held less than 1 year. ETF shares do not have redemption fees.
5. Taxes: Mutual funds distribute realized taxable capital gains to investors at the end of each year. The taxes you pay on those distributions are cost. ETFs are more tax efficient than mutual funds because they create and redeem new ETF shares “in-kind”, which allows the fund manager to unload low-cost basis securities without shareholders incurring a realized capital gain. The actual process is rather detailed and is in my ETF book. Vanguard funds are the exception. Vanguard ETFs and mutual funds are from the same portfolio. Consequently, the tax treatment is the same, although I will add that Vanguard does have other tax advantages because of the multi-share class structure. They can harvest tax losses within the fund because of cash redemptions on the open-end mutual fund share side.
Custody of ETFs and mutual funds
Custody is a consideration (Custody is where your account resides):
1. Directly with the fund company: Investors who have Vanguard accounts can buy open-end Vanguard mutual funds at no commission. However, trading open-end mutual fund shares is limited to once per day at the end of the day at the NAV.
2. Indirectly with a brokerage firm (e.g., VBS, Fidelity, Schwab, Merrill): Investors pay a commission to buy open-end mutual funds and ETFs. Commission costs vary considerably between firms and are different for mutual funds than for ETFs. Investors can trade ETF shares anytime during the day when the market is open at the current market price. Open-end Vanguard mutual fund shares can be purchased through several brokerage firms also. However, the trade will take place at the end of the day at NAV and there will be a commission.
Convenience of ETFs and mutual funds
The convenience factor:
1. If you want simplicity and want only Vanguard funds (no other investments or other company’s funds) then open a Vanguard account and buy open-end mutual funds.
2. If you want one account that includes Vanguard funds and other investments such as individual stocks and bonds, ETFs, and other company’s mutual funds, then you should open an account at a discount brokerage firm that gives you access to all of those investments.
Making the decision between ETFs and mutual funds:
1. If you plan to buy only Vanguard funds – go directly to Vanguard. This is the least expensive option for Admiral Share class investors. For Investor Share class investors, this also is a low cost option if you are buying multiple funds in a diversified portfolio and if you are dollar-cost averaging.
2. If you plan to buy other investments in addition to Vanguard funds and want the convenience of one custodian – choose a low cost custodian and buy Vanguard ETFs rather than Vanguard open-end mutual funds. The commission cost is lower and the expense ratio for ETFs is also lower (slightly lower that Admiral shares also). That would provide the convenience and low cost.
3. If you don’t care about having multiple accounts or the inconvenience of tracking and trading in different places and you are investing regularly, then go with Vanguard directly for the Vanguard funds and open a low-cost custodian account for all the other investments.
4. If you are buying only a couple of Vanguard funds one-time, then it is a coin toss. You can go direct through Vanguard or buy ETFs. The cost difference is too close to call. For Investor class shareholders, going through a low-cost broker and buying ETFs is probably the lowest cost option in the short-term, however direct Vanguard investors can convert Investor class shares to Admiral Shares Class when the fund reaches $100,000 in assets.