(PUB) Investing 2016

664 / 708

6 • Fund Family Shareholder Association
MUTUAL FUND, or exchange-traded
fund (ETF)—which is better? The com-
mon assumption behind that question
is that ETFs, being the newer Wall St.
innovation, must be superior to the
stodgy old mutual fund that our parents
and grandparents invest in.
But don’t count out the old fash-
ioned mutual fund just yet.
I’ll go through the pros and cons in a
minute, but let’s start at the beginning.
ETFs, like index mutual funds, provide
an easy way to buy a predetermined
basket of stocks or bonds. In the simplest
terms, an ETF is just an index fund. What
sets ETFs apart is that they trade through-
out the day, like a stock, as opposed to
mutual funds, which are priced just once
a day at the market’s close.
The first ETF launched in the U.S.,
in 1993, was State Street’s SPDR S&P
500 ETF (SPY). Though ETFs have
taken off since then, they weren’t an
overnight success. It took nearly two
and a half years for the second ETF,
State Street’s MidCap SPDR (MDY),
to hit the market. ETFs holding foreign
stocks didn’t arrive until 1996. Seven
years after SPY’s inception, there were
only 30 ETFs in the U.S., and Vanguard
didn’t enter the market until 2001. The
first bond ETFs came on the scene in
2002, and commodity ETFs landed
in 2004. Since then, the ETF industry
has exploded. In 2008, ETFs held a
combined $531 billion in assets. Today,
there are nearly 2,000 ETFs available in
the U.S., and assets invested via ETFs
sit just shy of $2.4 trillion. Clearly
something is drawing the attention and
dollars of investors and traders.
ETFs, like shiny new toys, are con-
sidered superior to old-school mutual
funds. And that superiority is gener-
ally built on the foundation of four pil-
lars: low cost, tax-efficiency, transpar-
ency and liquidity. But are these pillars
unique to ETFs, or do mutual funds
share those qualities? And if they are
shared qualities, are ETFs still better?
Let’s take costs first. Are ETFs really
cheaper than index mutual funds? First,
it’s important to make sure you’re com-
paring index funds and ETFs with simi-
lar, if not identical, investment objec-
tives. At Vanguard, for instance, where
many index funds offer an ETF share
class that tracks the exact same index
benchmark, the lower-cost Admiral
shares of its mutual funds operate with-
in one basis point (0.01%) or less of
the ETF shares. So, if you can meet
the minimum for the Admiral shares
(typically $10,000) then, from a cost
perspective, the ETF has no advantage
over the mutual fund, and vice versa. As
you can see in the table above, different
share classes of Vanguard’s classic 500
Index operate with varying expenses
depending on how much you have to
invest. Only the original Investor shares
of the fund are more “expensive” than
the ETF shares.
Okay. Number two. In theory, ETFs
should be more tax-efficient than mutu-
al funds. In practice, though, index
mutual funds are already extremely
tax-efficient, and, at least at Vanguard,
it is a toss-up which will leave you
with more money after taxes are paid.
When I matched up 36 ETFs with
their Investor share siblings and com-
pared after-tax returns over the past five
years, in half of the instances the ETF
shares led—which means that in half
the comparisons the index mutual fund
outperformed after taxes. And that’s
using the most expensive share class
of Vanguard’s index mutual funds. Use
a cheaper share class, and the balance
tips toward the fund over the ETF.
Yup, the old, tried-and-true open-end
fund is probably just as good as the ETF,
if not better, when it comes to taxes. (For
an in-depth review of Vanguard’s funds’
tax efficiency, see the May and June
2016 issues of the newsletter.)
Let’s look at the third pillar: trans-
parency. ETFs have to disclose the
stocks in their portfolio every single
day, whereas mutual funds only have to
update their holdings every quarter—
making ETFs more transparent, right?
Well, first, remember that at Vanguard
ETFs are simply another share class of
its index mutual funds, so they own the
same basket of stocks, and hence one
can’t be more transparent than the other.
But putting that aside, updating hold-
ings daily only increases transparency
if those holdings are actually changing
each day. While an active portfolio
manager may buy a stock one day that
he or she didn’t own the day before
or even completely rejigger a fund’s
portfolio, indexes (and index funds)
don’t work that way. Most indexes only
reconstitute their portfolios, a process
of reviewing and changing their hold-
ings if necessary, once a quarter or once
a year. So for an index-tracking portfo-
lio, whether a mutual fund or ETF, the
holdings simply aren’t changing day to
day or even week to week.
Which brings us to that fourth and
final selling point: liquidity, the ability
to easily buy or sell an asset any time the
markets are open. Stocks trade all day
long and, hence, are very liquid. Your
house, on the other hand, is not liquid,
as it would take several weeks to sell
in even an optimal scenario. Because
ETFs can be traded throughout the day,
they are more liquid than mutual funds,
which only trade at one price, their
net-asset value, at the end of the day.
ETFs also offer more trading flexibility
in terms of setting stop-loss orders or
short-selling—things you can’t do with
a mutual fund. (Though, I seriously
question whether most investors should
be engaged in either market-timing or
INVESTMENT VEHICLES
Funds for Investors. ETFs for Traders.
Vanguard’s 500 Index
Share Classes
Share Class
Minimum
Investment
Expense
Ratio
500 Index $3,000 0.16%
Admiral 500 Index $10,000 0.05%
S&P 500 ETF None 0.05%
Inst. Index Inst. $5,000,000 0.04%
Inst. Index Inst. Plus $200,000,000 0.02%
500 Index Inst. Select $5,000,000,000 0.01%