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By Christine Benz | 03-22-2014 01:30 PM

Become a Better Index Investor

Roundtable Report: Experts dig into the ETF versus index fund debate, active and passive strategies, fixed-income benchmarks, factor investing, and much more.

Christine Benz: Hi, and welcome back to Morningstar's Individual Investor Conference. I'm Christine Benz, director of personal finance for Morningstar, and this is our session, Become a Better Index Investor.

We're going to just talk about how to select the best index funds and exchange-traded funds. We'll also talk about how to put them together in a portfolio. 

I'm happy to say that we have three terrific panelists joining us here today to walk us through this important topic. Mark Balasa is here from the firm Balasa Dinverno Foltz. He is co-CEO at the firm. He is also chief investment officer. He has also been a long-time friend of Morningstar.

Jared Watts is also here. Jared is a portfolio manager for Morningstar Investment Management.

And last but not least, Ben Johnson is here. Ben is director of passive funds research for Morningstar.

Thank you all for being here.

Mark Balasa: Thank you.

Jared Watts: Thank you.

Ben Johnson: Thanks for having us.

Benz: We have a lot of material to get through, but I'd like to start with the index fund versus exchange-traded fund question. I think a lot of investors wrestle with this. Now that the dust has settled and some of the excitement regarding ETFs has died down or maybe not died down, is there a significant difference in what factors should investors bear in mind when trying to decide whether to just invest in a traditional index fund or to use an ETF. Ben, can you tackle that question for us?

Johnson: Yes. I think that's a question that's getting evermore difficult to answer by the day, and it's really gotten to the point where it almost boils down to a matter of personal preference. Do I place some sort of premium, some sort of value on the liquidity feature of an ETF and some of the flexibility of that wrapper vis-a-vis a traditional index fund? I think Vanguard in particular, whose ETF is really just a separate share class of their traditional index funds, has made that math increasingly difficult and made the decision increasingly subjective.

The other element, I'd throw in there is one of breadth of choice. So the breadth of choice is more extensive--sometimes for better, other times for worse--in ETF's vis-a-via index funds, but it's becoming an ever-finer decision and one, I think, that is more a matter of personal preference over time.

Benz: Ben, you mentioned that some liquidity benefit accrues to the ETF. Do you mean mainly that ability to trade intraday that you get with an ETF that you don't have with [mutual funds]?

Johnson: That ability to trade intraday, and I would hope that most investors aren't exercising that especially with core allocations within their portfolios. But if they place some sort of value on the idea of having that ejector button in case of an emergency, then that might lead them toward getting, say, broad U.S.-equity exposure in an ETF wrapper that might also be available in an index fund wrapper. But that is a very fine consideration. We're not talking about a black-and-white decision at that point.

Benz: So there is in some cases a tax-efficiency benefit to being in the ETF versus the traditional index fund, but in some cases it's not a benefit. In the case of Vanguard's equity products, for example, it's not a big benefit either way. You can get tax efficiency with either wrapper. Mark, when you think about tax efficiency, do you typically recommend the ETF, or how do you decide whether to use an ETF or a traditional index mutual fund?

Balasa: I agree with what's already been said. The distinctions are becoming kind of a subtle, if you will. If it's a well-run indexed fund, they should be able to really successfully suppress, I should say, the distributions. In some ways, perhaps it's a little more ironclad with an exchange-traded fund in terms of controlling your tax liability, but for most part, it's a subtle difference. I think that's one of the key advantages of ETFs and index funds over traditional actively managed funds, though.

Benz: Jared, can you talk about why ETFs and index funds in general tend to be more tax efficient certainly than say your typical actively managed product?

Watts: Sure, absolutely. And it's really more about the overall construction and mechanics. The ETFs are more tax-efficient, simply because of the design where they have the ability to basically neutralize some of the tax impact that an active manager or mutual fund would not be able to do since they are required to make a distribution once per year.

ETFs have more flexibility in the overall timing of when that would take place just through the buying and selling of the underlying shares. So it's more of a structure type of difference between especially active mutual funds and ETFs.

Benz: Just to be clear, index products and ETFs will only be tax-efficient in relation to capital gains. If the product is spinning off some sort of current income, it's not going to matter whether you own it in an ETF index fund or in an actively managed product, you pay the tax bill either way?

Johnson: That's a really important point. At the end of the day, if you have a capital gain in that position that accrues with time, when you go to sell it, tax efficiency becomes irrelevant. It's the tax efficiencies sort of during the holding period of that product, which as Jared pointed out, primarily springs forth from the way the portfolio is managed. It's a passive portfolio. Turnover tends to be much lower in the case of the ETF, the uniqueness of the in-kind creation and redemption mechanisms. So they are not taking cash directly from shareholders. They are taking securities directly from authorized participants and exchanging those.

So there is that sort of mitigating of the potential for taxable events in that wrapper. The source of that tax benefit is accrued over the holding period, but it does not necessarily mean that you're off the hook for capital gains taxes when you go to sell these instruments.

Balasa:  I'll make one small point between ETFs and index funds. If you are a small investor--let's say you're saving for your children's education, or they are doing it for themselves, they are putting in monthly deposits or are buying it monthly--ETF transaction fees can add up as opposed to if you go straight to the fund provider with small purchases, assuming you've met the minimum [investment threshold]. That's a more cost-efficient way to do it because you don't take a charge. So it's small difference perhaps, but for people making small contributions, there is a difference.

Benz: And there are increasingly, though, commission-free platforms, right, Mark?

Balasa: There are. That's correct.

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