Ah, the age-old question. If there’s a bigger rivalry in the entire investing landscape, I don’t know of it. Here’s the deal. When we refer to index funds, it’s important to know that technically, this can mean one of two things: a mutual fund or an exchange-traded fund (ETF). Said another way, there are both index mutual funds and index ETFs—both can be considered index funds.
A lot of investors agonize over which of these is the absolute, 110%, stunningly perfect vehicle for their portfolio, but here’s the funny thing: for the most part, it doesn’t matter. For a long-term, buy-and-hold strategy such as ours, both index mutual funds and index ETFs are perfectly viable. What matters far more is the composition, costs, and characteristics of the underlying fund. This is not to say there aren’t some key differences between the two—there are. But these differences weigh more into the logistics of how you invest, not into the long-term performance of your portfolio. Let’s get into it.
First, let’s start with the similarities between the two. Both mutual funds and ETFs are funds created by a fund company that, in simplest terms, are collections of stocks, bonds, or other assets. Stock funds are the most common, so most of the time we will be referring to these in our discussion.
This means that when you buy a share of the fund, you are by extension buying shares of all the stocks that make up the fund. This is important to understand, because for our strategy, the greater difference is not “mutual funds vs ETFs,” but rather how the fund itself differs from others. Both ETFs and mutual funds derive characteristics—such as risk, volatility, performance and so on—partly from those of the underlying securities. Understanding the makeup of the fund is key.
Also, both can be either passively managed (aim to mirror an index) or actively managed (subject to the skill of a fund manager who actively selects stocks for the fund). Both of these approaches will have costs commensurate with the approach.
“…the greater difference is not “mutual fund vs ETF,” but rather how the fund itself differs from others.”
To illustrate this point, let’s consider an example. Vanguard’s funds are particularly useful here, because they offer many mutual fund-ETF pairings that are different share classes of the same fund. This means that the fund itself is exactly the same whether you buy the mutual fund version or the ETF version; they’re just packaged and sold differently.
For example, we’ve discussed Vanguard’s Total Stock Market fund before, and it comes in both a mutual fund version (VTSAX) as well as an ETF version (VTI). Both funds have the exact same composition, meaning that both aim to mirror the entire U.S. stock market, contain the same 4,026 stocks (in the same weighting), and so on. They also have almost identical costs, as seen here:
|VTSAX (Mutual Fund)
As a result—and no surprise here—both funds perform nearly identically to each other. Morningstar Research (a popular website for researching funds) has a metric that evaluates the growth of $10,000 over the past 10 years had it been invested in a given fund. How closely did the end balances of our two funds end up? The mutual fund version (VTSAX) ended up with $36,417, just slightly behind the ETF version (VTI) which had $36,438. That’s a difference of $21—on a balance of over $36,000.
As I said, nearly identical. The fact that one is a mutual fund and the other is an ETF makes effectively zero difference.
So what are the differences between mutual funds and ETFs? Why would investors choose one over the other? Well, as I mentioned before, these differences will largely be important to investors who have a strong preference for investing in a certain way. Let’s go over some of the differences in-depth.
The main difference between mutual funds and ETFs lies in how they are sold. When investors buy shares in a mutual fund, they purchase those shares from the fund company through their brokerage or trading account. The price that investors pay per share for a mutual fund is directly anchored to the value of the underlying securities in the fund. This is known as a fund’s NAV, or net asset value.
Here’s how it works. At the end of the trading day, the issuing fund company adds up the total value of the fund, which is the value of all the underlying securities in aggregate plus any cash in the fund. Once the total value is determined, the fund company subtracts any liabilities to get the fund’s net assets. (As you might guess, this number can be quite large; for example, Vanguard’s Total Stock Market Fund lists total net assets of $1.2 trillion.) Finally, the fund company divides the net assets by the number of outstanding shares in the fund, and this becomes the fund’s share price.
So, as a quick example, a fund with total net assets of $100 million and 1 million shares outstanding would have a price of $100 per share ($100 million divided by 1 million shares). One downside to this pricing model is that because the price per share is determined at the end of the trading day, investors often do not know what price they are paying at purchase. However, because the price is anchored to the NAV, it is always the “fairest” price possible.
“Because ETFs are sold on an exchange, the share price also reflects the forces of supply and demand.”
ETFs, however, are different. ETFs are funds that are packaged and sold on a stock exchange (much the same way that stocks are). Like mutual funds, the base share price for an ETF is also calculated off of the NAV, but because ETFs are sold on an exchange, the share price also reflects the forces of supply and demand.
This is reflected in what is called the bid-ask spread for the fund. If demand for the fund is high, ETF investors may pay a slight premium to buy shares, whereas if demand for the fund is low, they might be able to get a slight discount. As Taylor Larimore explains, “Because ETFs are market traded, they can trade at a slight premium or discount to the value of the underlying securities held in the fund. Generally, the premium or discount is not very large, but you need to be aware of it” (The Bogleheads’ Guide to Investing 47). Vanguard’s research has noted that the average bid-ask spread amounts to a few pennies per share, so most of the time it’s largely irrelevant.
This pricing model also means that the share price for an ETF is valued constantly throughout the trading day; this means that (during trading hours) investors will always know the price per share when they buy or sell. Some investors value this real-time pricing aspect of ETFs.
Advantage = If able to buy at a discount, ETFs take it. If buying the ETF at a premium, however, mutual funds win.
Access to various mutual funds and ETFs can also be a very important consideration for investors. Employer-sponsored plans aside (which typically have fixed fund menus with various funds from several brokerages), investors will typically find their mutual fund selections limited by their chosen brokerage—unless they’re willing to incur significant costs.
The general rule is that investors choosing to invest in mutual funds should stick to the fund family belonging to their brokerage in order to avoid unnecessary costs. For example, an investor who chooses Fidelity as their brokerage will largely want to stick with Fidelity’s mutual fund options to avoid costly fees. Should they want to invest in Vanguard’s VTSAX, for example, they would have to pay a $75 transaction fee—and this every time they want to purchase shares. You can see how this can quickly add up, and begin to affect overall portfolio return. Our investor would be much better off going with one of Fidelity’s equivalent funds (Fidelity’s Total Market Index Fund, FSKAX, or Fidelity’s ZERO Total Market Index Fund, FZROX), which have no transaction fee and are a perfect replacement for VTSAX.
Fortunately, for investors that choose mutual funds, most brokerages offer a selection of index mutual funds that are very competitive. We will get into this more in Part 11, when we learn how to research funds; I’ll be including a full list of index fund options by every major brokerage.
Most major brokerages now offer ETF trades commission-free, which essentially opens up the full spectrum of index ETFs to any investor, at any brokerage, without costly fees. This is a game-changer.
ETFs, however, have much wider availability, and are generally not restricted anywhere near as much as mutual funds. Most major brokerages now offer ETF trades commission-free, which essentially opens up the full spectrum of index ETFs to any investor, at any brokerage, without costly fees. This is a game-changer. It means that if our investor above had a strong preference for Vanguard’s funds, but holds an account at Fidelity, they still can go with Vanguard: they can simply select to invest in Vanguard’s Total Stock Market ETF (VTI)—without paying a single penny in fees. This opens up the fund landscape substantially to investors, regardless of brokerage.
Advantage = ETFs.
Minimum Initial Investment
Many mutual funds (not all) have a minimum initial investment, which essentially means that your initial investment must be at least a certain amount to “buy in” to the fund. Depending on the fund, this can be significant. For example, Vanguard’s Total Stock Market Index mutual fund, VTSAX, has a minimum initial investment of $3,000. If, for example, you only have $500 to invest starting out, you’re out of luck—you don’t meet the minimum, and are forced to either save it up, or find an alternative.
It’s important to note that most employer-sponsored retirement accounts do not have minimums to invest in their mutual fund selections, so if you’re investing in one of these, a fund minimum is likely nothing you need to worry about.
The starting cost to invest in an ETF is the cost of only one share. This makes ETFs much more accessible for those just starting out.
On the other hand, the starting cost to invest in an ETF is the cost of only one share (or perhaps not even that—we’ll get to fractional shares in a moment). This can make ETFs much more accessible for those just starting out.
A good tactic when starting out is to check and see if the mutual fund you like has a required minimum; if it does and you don’t meet it, see if it has an equivalent ETF. As we discussed previously, it just so happens that our mutual fund (VTSAX) has an equivalent ETF (VTI) that is the perfect alternative—and will cost much less to buy in to the fund. Instead of VTSAX’s initial cost of $3,000, VTI allows us to buy in for the cost of only one share (which, as of this writing, is $191.42). Keep in mind that if you really want the mutual fund version, selling the ETF shares and buying in once you have the minimum later is always an option.
Advantage = ETFs.
Mutual funds have traditionally had an advantage over ETFs when it comes to the ease of automation. In a mutual fund, you are able to set up automatic investments for your contributions, whereas with an ETF (because they are traded on an exchange) you are forced to purchase shares manually.
So how does automatic investing work? Let’s say you want to automate your investments entirely, have $500 per month transferred from your checking account to your Roth IRA, and then have it automatically invested in your choice of fund(s) once it arrives in your Roth. With mutual funds, you can do this. It truly is “set it and forget it,” and makes the process much easier for those who want to minimize the amount of work involved.
You might have noticed that I said mutual funds have “traditionally” had an advantage here. This is because some brokerages have started offering automated investments into ETFs; it’s important to note that at an industry level, however, this is still in the incipient stage, and ETFs have a long way to go yet when it comes to automation.
Advantage = Mutual funds.
Another point of difference between mutual funds and ETFs has, to this point, been the ability to purchase fractional shares. A fractional share, as you might guess, is a unit purchased in a fund that is less than one whole share.
Here’s how it works. Once you’ve bought in to a mutual fund (i.e. met the initial minimum—if there is one), you are able to invest any dollar amount, regardless of whether or not that amount is enough to purchase a whole share. If your fund’s share price is $147, but you only have $50 to invest, you can. Due to the way mutual funds are structured—and because purchases are measured by dollar amount—this essentially means you are able to purchase amounts less than one share—or a fractional share. In the above example, you would be purchasing 0.34 of a share, which would just be added to your other holdings. Mutual fund advocates like this, because it ensures that you will never have money “waiting on the sidelines” to invest.
Mutual fund advocates like fractional shares, because it ensures that you will never have money “waiting on the sidelines” to invest.
ETFs have not traditionally been able to offer this, as they are packaged and sold on an exchange in whole shares. You either have the amount to purchase a share, or you don’t. Using the same example above, if you have $50 to invest, but the share price is $147, you are forced to wait until you have the entire amount before you can purchase the share. This sometimes results in having money not invested in the market—or waiting on the sidelines.
However, it’s important to note that many brokerages (including Vanguard) are beginning to offer fractional ETF shares, which is quickly making this point of difference obsolete.
Advantage = Mutual funds…for now.
There is one final consideration when making the decision between ETFs and mutual funds: tax efficiency. ETFs tend to be slightly more tax efficient than mutual funds because of the way they’re structured. Mutual funds have to buy and sell the underlying securities (generating capital gains inside the fund) when new shares are issued, or when investors exiting the fund redeem existing shares. ETFs, which use “creation units” to buy and sell assets in the fund collectively, don’t have this problem.
The sole exception to this is Vanguard’s mutual funds, which due to a patented process, rival their ETFs for tax efficiency. Put another way, you will not notice any meaningful difference in tax treatment between Vanguard’s mutual funds and their ETFs. Due to the patent, they are unique in this. This patent expires soon, however, so we may see some of these changes close the gap with other fund family’s mutual fund-ETF pairings in the future. We’ll have to see.
However, an equally important point is that index funds in general (such as the ones we’ve mentioned) are extremely tax efficient already. This is because, in addition to the above, the tax efficiency of a particular fund directly relates to how often the securities within it are “changed out” (this is known as a fund’s turnover), and thereby how often capital gains are generated within the fund.
Index funds—both mutual funds and ETFs—have very low turnover because they are passively managed and designed to track an index. As a result, index funds are inherently highly tax efficient, regardless of share class.
Advantage: (If at Vanguard) Neither. (If at other brokerage) ETFs.
Putting It All Together
…in one handy chart. Here goes!
|Priced at the end of the trading day
|Real-time (during trading hours)
|Always anchored to NAV
|NAV + influenced by supply and demand
|Typically limited by fees to fund family at brokerage
|Commission-free nearly everywhere
|Can be significant (e.g. VTSAX = $3,000)
|Cost of only one share
|Less tax efficient*
|More tax efficient*
We’ve covered a lot of ground so far. If you’ve been following the guide, you now have a good understanding of when you’re ready to invest, what index funds are, the advantages they offer over other types of investments, the three main asset classes we will be using to build a portfolio, and which investment vehicle fits you best: mutual funds or ETFs. Leave me a comment below, let me know which one fits you better, and why!
We’re now ready to get into the specifics of how to build a portfolio. In Part 9, we are going to cover the most important aspect of the entire guide: asset allocation. See you there!
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