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Traditional Index Funds vs. ETFs: Which to Choose?

Christine Benz

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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Benz: So they get rid of the shares that have the low cost basis?

Dickson: Exactly, but traditional mutual funds can do sort of an opposite trade as can ETFs, which is if there are losses in the portfolio, to realize those losses. Because one thing an in-kind redemption can't do is actually realize losses. But either through redemptions in traditional mutual fund share classes, where you sell the high cost basis lots, you would maximize the loss that you realize in that case. And that can offset capital gain. So it's a nice feature to have in the ETF, but it's not the be-all and end-all of tax management in an investment portfolio.

Benz: Let's talk about trading flexibility and trading costs. I think a lot of people look at ETFs as being more flexible because they do allow that intraday trading. That's something that you cannot do with a traditional index mutual fund. Let's talk about the whole realm of trading both cost and flexibility.

Dickson: So when we think about trading costs, it's not just sort of what you pay. It is also what commissions might be charged if you are buying it in a brokerage platform. It's what’s the bid-ask spread in the marketplace--that is there is a market maker in between who is going to, in part of their normal market making activities, try to buy low and sell high. And what that means for an investor is if a market maker is going to sell you a position that you want to buy, it's going to be at a little bit of higher price than where they would purchase it from you, and that's what called the bid-ask spread.

And that can be anywhere from maybe a basis point or two to 15 or 20 basis points depending on how liquid that ETF is, both in terms of its own portfolio trading as well as the underlying securities that might make up the portfolio and how liquid those are. So, you have to take a total-cost mentality in thinking about what the true cost is of the ETF, and that would be not just the ongoing expense ratio of the ETF but also any transaction costs, which would be the commission, bid-ask spread, and so forth.

In terms of flexibility, I actually think that that's a bit of an interesting question. There's this notion that ETFs are more flexible because you can trade them at any time during the trading day, and that is certainly the case. I mean, if any time the market is open between 9:30 and 4:00, let's say in the U.S., you can usually trade that ETF. But in a certain context, you can trade a mutual fund anytime, 24 hours a day, online, you can go in.

While you won't necessarily get the price at that exact point in time, you know you will get the next net asset value as determined, usually at 4:00 the following day or that day, if it's a same-day transaction before 4:00, and you know with certainty you are going to get that. When you do a trade with an ETF, there might be what's called a premium or discount relative to the true underlying value of the securities, and so there can be an often small difference between that. And so you may pay up or you may get a little bit of a bargain. It's not always the case that you know that you're getting the true value of the portfolio even though you're getting certainty on price with the ETF. What you're getting with the mutual fund is the certainty of value at the time that it's determined.

Benz: I'd like to cover with you what I would call sort of creature comforts: how easy is it to own this thing and continued to invest in it. Let's compare and contrast ETFs and traditional index mutual funds from that standpoint?

Dickson: Right. So, a lot of this does come down to often subjective considerations in this decision.

Benz: What you care about?

Dickson: What you care about, exactly. If you want the control of the trading flexibility that an ETF may provide, then that might trump other small differences either in terms of cost or in terms of convenience features that might be available on the mutual fund side.

On the mutual fund side, one thing that has built up over the course of the decades of the mutual fund industry is not just the investment management pieces of mutual funds, but also the convenience features that shareholders have come to enjoy. You think about automatic investment or withdrawal programs. If you want to take $100 out of your bank account every week or every month, and have that invested in ABC Mutual Fund, you can do that very easily and automatically.

With an ETF that's often quite a bit harder to do because you need to get it into the brokerage account, and then you need to transact in the number of shares often of the ETF as opposed to dollars that you often transact in mutual funds. And that distinction means you have to do an extra step to get the money there and then put in the trade, so that it matches up with the amount of money that you want to put in and make sure that the type of trade that you're doing doesn't get you outside of that dollar amount that you want to invest.

So, it requires a little bit more handholding in terms of regular trading in the ETF versus the mutual fund which can often be quite convenient for investors making regular purchases or withdrawals.

Benz: How about dividend reinvestment?

Dickson: So, there is often a slight difference in dividend reinvestment at least in the U.S. On the mutual fund standpoint, if you decide you want reinvestment of your dividend and capital gains distributions, that's done pretty much automatically on the ex-distribution date, basically right as it's occurred, so that you're never out of the market, if you will.

Within ETF, typically when the distribution gets made, even if you have a dividend-reinvestment plan set up through your brokerage to reinvest the distributions, it's often not done until four or five days after the distribution is made. So, at least for that distribution amount, that's been out of the fund for that period. And even when it is put back into the fund, it is done through an open-market purchase in most cases. That is, the brokerage firm, if it's in a drip-type program, or you, if you've had it in a sweep account or some other money market account, must go out and purchase those shares to reinvest the distribution amounts. So, it's not an automatic book-keeping entry in the same way it often is for mutual funds.

Benz: Joel, there are lots of considerations here for people attempting to choose between ETFs and traditional index funds, thanks for walking us through them.

Dickson: Thanks for having me.