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  • Comparing ETF and Mutual Funds

    Posted by Frugal on October 4th, 2006

    Most ETF have a very low expense ratio. Assuming that you can find an equivalent low-fee mutual fund that tracks the same index/sector as the ETF tracks, do you buy the mutual fund or the ETF?

    Annual expenses and tracking errors

    Using Vanguard as my research base, I went through several comparisons between Vanguard index funds and index ETFs. The annual expense fee between difference is in the order of 0.03%. The tracking errors to the index between the index funds and index ETFs are usually less than 0.5%. For the fee difference, it probably won’t matter in the most cases. The tracking errors however are not controllable nor predictable. Therefore, you won’t be able to make a decision based on the tracking error either. Base upon the annual expense and tracking performance, it would be hard to make any decision between the two choices.

    Trading Commision

    However, there are other fees that you will incur when you buy either ETF or mutual funds. Those fee more than likely will be bigger than the fee difference between ETF and mutual funds. Since ETF trades like a stock, normally you will need to pay for stock trading commission, everytime you add to or sell from your stake. At $5000 everytime, your trading commission (using $5) easily reaches 0.10% or above, 3 times the annual expense difference. Certainly if you do that more than 1 time per year, you will be looking at a lot more trading fees.

    For mutual funds, the buy/sell trading fee is usually much higher (about $20) than stock commission, unless you open an individual account at Vanguard or whichever fund family that you decide to purchase. Outside of having accounts at the fund company, I only know of FirsTrade that offers free buy/sell of Vanguard funds (send me email for referal code to get 5 free trades). The message here is that depending on how/where you buy your ETF/mutual funds, the commission fee will have a higher impact.

    Bid/Ask spread

    Besides annual expense and trading commissions, the biggest disadvantage for ETF is that there is a non-zero bid/ask spread. Repeating this process enough times, most likely you will be paying for the spread. For the case of mutual fund, you don’t pay for any bid/ask. Instead you pay for the NAV or net asset value when you buy mutual funds.

    Advantages of ETF

    Despite the possible higher trading commissions and bid/ask spread, ETF is more tax-efficient in that mutual fund may incur capital gain (and therefore tax) when there is some changes in the index itself. Furthermore, there is no restrictions on the holding period, and you can trade ETF all day long. I’ve heard that there are some extremely competitive funds that allow you to get intraday price by hour or every two hours. The inability to trade intraday in a mutual fund is not necessarily a disadvantage. Actually it forces you to be more calm and thinking more throughout the day, instead of letting you sell/buy emotionally.

    At last, with ETF, it’s much easier to do “Short Against The Box“. You can open a short position via buying puts or selling calls or short-selling your own shares. There is some caveat in doing such trades. You can find out the details at the end of this article. ETFs allow a swing trader to trade a market or a sector easily, and can unlock any long term gain partially through short sales.

    Here is a great article written by the author of The Four Pillars of Investing on the comparison of ETF and mutual funds. Take a look and see what he thinks.

    You can research any ETF at ETF connect. Yahoo finance provides easy search for both ETF & mutual funds.

    More related posts:
  • Long/short mutual funds revisited
  • Portfolio Update: Bought some mutual funds

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    4 Responses to “Comparing ETF and Mutual Funds”

    1. Ray Says:

      There was an article recently in Forbes or Kiplingers in the last month or two which addressed this same issue. After doing all the math and figures it was determined that a mutual fund offers a greater monetary advantage over ETFs.

    2. Frugal Says:

      The advantage of ETF is for trading. In the very long term however, I agree that low-fee mutual fund may be slightly better. I will be careful with any expense ratio of more than 0.7% for non-specialized mutual funds.

      In summary, you will pay bid/ask spread at the time of buying/selling ETF which you don’t need to incur for mutual funds.

      The biggest swing factor is still how you buy/sell your mutual fund/ETF, whether you pay $17 at Scottrade everytime you rebalance or buy, or you pay $0 at FirsTrade or Vanguard everytime.

      The assumption here is that you don’t do the free automatic dollar investing.

    3. Trent Says:

      The main advantages of an ETF are for either day-traders (who can time their entry and exit) or for very long-term holders, who will benefit from the tax-efficiency.

    4. Frugal Says:

      That’s a good summary, Trent.