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By Christine Benz | 10-18-2012 01:00 PM

Traditional Index Funds vs. ETFs: Which to Choose?

Vanguard's Joel Dickson weighs the similarities and differences between the two vehicles, commenting on tax advantages, trading flexibility, dividend reinvestment, and more.

Christine Benz: Hi, I'm Christine Benz, for Morningstar.com. The decision about whether to buy a traditional fund or an exchange-traded fund isn't black and white. I recently sat down with Joel Dickson, a senior investment strategist at Vanguard's investment strategy group to discuss some of the key factors to bear in mind when making that decision.

Joel, thank you so much for being here.

Joel Dickson: Thanks for having me.

Benz: We have seen this barrage of new exchange-traded funds. We've also seen a lot of investor dollars flowing into exchange-traded funds. So investors might naturally assume they want to be in the hot new vehicle versus a traditional index mutual fund. I'd like to talk through some of the key considerations that someone trying to make that decision should bear in mind. Let's talk about the key differences between those two vehicles.

Dickson: Yeah, actually in some ways I'd like to start with the similarities, and I have the saying that the F in ETF stands for fund. And in fact in many ways, ETFs and traditional mutual funds are very similar. Think of them as a diversified pool of assets for investors to access stocks and bonds and potentially other markets. You have a number of investors coming together. [Traditional funds and ETFs] tend to have the same regulatory and tax rules that they follow, by and large. There are some exceptions, but generally that's the case.

I think the main difference is that with the mutual fund portfolio, you as the investor pretty much interact directly with the portfolio; that is, you buy and sell from the fund. It might be through an intermediary like a financial advisor, but ultimately the interaction is at the fund level.

With an ETF, generally the interaction is on a brokerage or an exchange, and so it is another person buying and selling shares that occurs in terms of how investors interact. So they don't interact directly with the fund. And as such, then you have other considerations around trading. There are some tax issues, and there might be some cost issues that arise where there can be some little differences.

Benz: I'd like to home in on a few of those. The tax one has been widely touted as perhaps an advantage in the ETF column. Let's talk about considerations that investors should bear in mind. If they are looking at an investment for a taxable account, will the ETF always be a better choice?

Dickson: Not always, and to a certain extent, we need to, again, put this sort of in the context of what are the differences between ETFs and traditional index funds. Most ETFs are index-based portfolios. Traditional index funds historically have also been very tax-efficient in terms of providing low capital gains realizations relative to actively managed funds and so forth. So, a lot of the difference, if you will, between ETFs and index funds really isn't a difference. It's that they are both indexed portfolios and will tend to be fairly tax-efficient, all else equal, relative to more actively managed strategies.

Now that said, the ETF, again, I think sometimes is mistakenly thought of as tax-free, that it can never have capital gain distributions. But in fact, ETFs do and can. They follow the same tax rules as index mutual funds, but there are some mechanisms by which ETFs can try to lessen the tax impact in the portfolio, mainly through this process called in-kind redemptions, which is when redemptions occur from an ETF portfolio, they tend to be done in securities rather than cash and that can provide some tax advantages in the portfolio.

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