ETFs a Good Fit for Many Long-Term Investors, Too

Question: I have owned index mutual funds for more than 20 years, and I do little if any trading. Is there any advantage for the long-term investor to use exchange-traded funds over index mutual funds?

Answer: This is a question we get quite often. Many investors who have long used traditional open-end mutual funds may be less familiar with ETFs and therefore shy away from them. But there are a handful of compelling reasons why even buy-and-hold investors might choose an index-based ETF over a comparable index-based traditional open-end mutual fund, at least when it comes to investing new money. Whether you should move assets that have long been invested in traditional mutual funds to ETFs is another matter. But first let's look at some of the advantages of using ETFs for long-term investing.

Fee Advantages, but Watch Trading Costs
Among the most important considerations is the amount it will cost you to invest in each type of vehicle. ETFs and traditional mutual funds may hold identical baskets of securities because they track the same indexes, but ETFs often cost less. One reason for this is that ETFs simply cost less to run. Unlike traditional mutual funds, they don't have to pay an army of customer-service personnel or bear some of the other administrative expenses.

Although ETFs often provide a cost savings over comparable traditional mutual funds, this advantage diminishes in the face of other trading costs for investors. Shareholders of traditional mutual funds may buy or sell shares without paying anything extra, but shareholders of exchange-traded funds, which typically are traded through an account at a brokerage, may pay a commission for each transaction. The good news is that some brokerages--such as Vanguard, Fidelity, and  Charles Schwab (SCHW)--don't charge commissions for transactions involving their ETFs (Fidelity offers some iShares ETFs commission-free). Therefore, if your brokerage offers commission-free ETFs that are cheaper than their traditional mutual fund counterparts and that suit your needs, they might be your best bet. If, however, you will have to pay commissions to buy or sell ETF shares, you'll have to do some light math to find the cheapest option.

As an example, let's say that index fund A charges 20 basis points (0.20%) in annual expenses while an identical ETF charges 10 basis point (0.10%). Your first instinct might be to go with the ETF. However, let's say that using the ETF requires paying a $10 brokerage fee per transaction. That means for a $1,000 investment you'd pay $2 in annual expenses with the mutual fund, while with the ETF you'd pay just $1 in annual expenses but an additional $10 commission for a total of $11. In this case you'd save $9 the first year by using the traditional mutual fund. (Over time this cost advantage would be reduced, with the ETF becoming the cheaper option after 10 years.)  

Investing more frequently or in larger amounts changes the equation. For example, let's say that instead of a lump-sum investment of $1,000, you were going to invest $20,000. Now your annual fees would run $40 for the traditional mutual fund and $20 for the ETF plus the $10 commission, meaning you'd come out $10 ahead by using the ETF.

But what if, rather than invest the $20,000 as a lump sum, you prefer to dollar-cost average by contributing an equal amount each month for a year. Then your commissions would run $120, and your total cost for using the ETF would run $140 versus just $40 for the mutual fund. That's why owning traditional mutual funds may still be the better way to go for investors making multiple transactions throughout the year and who don't have access to commission-free ETFs.

Weighing Tax Efficiency, Tax Consequences
One less obvious advantage that ETFs have over traditional mutual funds for long-term investors involves tax efficiency. When shares of a traditional mutual fund are redeemed, the fund manager may be forced to sell holdings for cash to meet those redemptions, which can trigger capital gains distributions that add to shareholders' tax bills. By contrast, when an investor goes to sell shares of an ETF, those shares are simply purchased by another investor without the ETF having to sell any holdings. Thus, no capital gains are generated by the transaction. (Index-based ETFs and traditional mutual funds do, however, generate capital gains by selling holdings to match their indexes.) Also, when large investors redeem shares of an ETF, they may be given shares of the ETF's underlying holdings in what's known as an in-kind transaction. The ETF may give these large investors the underlying shares with the lowest cost basis as a way to get them off the books and thus reduce future tax costs for its shareholders.

Despite these structural advantages, in some cases a traditional index mutual fund, if run properly, can be just as tax-efficient as its ETF counterparts, as Morningstar fund analyst Mike Rawson points out in this article. Also, there's little advantage to the ETF structure versus a traditional mutual fund in the realm of bond funds because the bulk of these funds' gains comes from income payments that are taxed as ordinary income whether they come from a traditional fund or an ETF.

One more important point to keep in mind regarding taxes is that moving any money that's been invested in a traditional mutual fund in a taxable account to an ETF could trigger a hefty capital gains tax bill, especially given the market's strong performance in recent years. It may not make sense to transfer appreciated assets to ETFs just to save a modest amount in fees. So before making such a move, be sure to calculate the tax hit to see if it makes sense.

Trade While the Market Is Open
Another potential advantage of investing through ETFs is the fact that they can be bought and sold while the market is open, just like stocks. Shares of traditional mutual funds, by contrast, may only be bought and sold after the market closes. Because of this intraday tradability, ETFs are sometimes associated with day-trading and market-timing. But there's no reason for buy-and-hold investors not to use them, as well. Of course, a true buy-and-hold investor may not care whether he can trade shares during market trading hours. But for long-term investors who would prefer to be able to move their money into or out of the market in case of a sharp downturn, for example, ETFs provide this added dimension.

Some might argue that ETF investors' abilities to buy and sell shares during the trading day is a double-edged sword, one that opens the door to impulsive decision-making during times of market turmoil. In some cases, not being able to trade while the market is open and emotions are running high may, in fact, be the better choice.

Selection May Be Limited
One last thing to consider when weighing which type of investment vehicle to use is that not all index-basedmutual funds have ETF counterparts and vice versa. Many of the most commonly used indexes are available in both forms, but more esoteric index-based options might only be available in one form or another. Of course, there's nothing keeping you from choosing ETFs for some of your index-based investments and traditional mutual funds for others, either. That way you can customize your portfolio to best suit your needs.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.