Traditional Index Fund vs. ETF Cage Match

This article is part of Morningstar's Guide to Passive Investing special report.

Exchange-traded funds have garnered much of the buzz--and new assets--in the mutual fund industry over the past decade. But at heart, they're not a whole lot different from traditional index funds, which have been around since the 1970s. Most traditional index funds and ETFs track some type of benchmark, offering investors exposure to a market segment in a convenient package. Low costs and good tax efficiency are also hallmarks of many ETFs and index funds.

Yet there are small differences, too, when it comes to trading, tax efficiency, reinvesting dividends, and so on. In the end, the decision about whether to choose a traditional index fund or an ETF depends on the investor, as Alex Bryan discussed in this whitepaper. Choosing between these product types boils down to what features the investor values most, where and how he or she is investing, his or her level of assets, and other key factors.

Here's a head-to-head comparison of ETFs versus traditional index mutual funds.

Expense Ratios: Tie Exchange-traded funds initially garnered headlines as being cheaper than traditional index funds. But price wars have raged for nearly two decades, putting downward pressure on traditional index fund expense ratios. At this point, the two product types are closely aligned on the cost front. One major swing factor, however, is purchase size. Small investors might not qualify for the cheapest share class available for traditional index funds at firms like Vanguard and Fidelity, but low-cost ETF shares are available to investors regardless of purchase amount. However, those same ETF investors might pay commissions to buy and sell, which can erode the expense-ratio advantage of the ETF.

For investors with larger asset levels and long holding periods, ETFs and traditional index funds are fungible from an expense-ratio standpoint. However, as Alex Bryan notes in his paper, Vanguard's traditional index funds, which are large and managed at cost, put downward pressure on traditional index funds' expense ratios on an asset-weighted basis. That makes traditional index funds' asset-weighted expense ratios look lower than would be the case without the "Vanguard effect." Bryan points out that the "Vanguard effect" is also at work in the ETF space, though Vanguard has a smaller share of the ETF market than is the case in the traditional index fund space.

Trading Costs: Advantage Traditional Index Funds In the early days of ETFs, investors had to pay commissions to buy and sell, whereas most traditional index funds were available on a no-load, commission-free basis. These days, however, most large brokerage platforms offer at least some ETFs on a commission-free basis, so this isn't as great a disadvantage for ETFs as it once was. However, investors transacting in ETFs that aren't on the brokerage firm's "commission-free" list will still pay commissions to buy and sell.

Moreover, ETF investors can confront other transaction costs. ETFs may trade at small premiums and discounts to their underlying assets. Additionally, investors may confront bid-ask spreads and market-impact costs, particularly if they're buying or selling large amounts in ETFs with low liquidity or that hold less liquid holdings. Trading costs won't matter much to ETF investors who are trading little, stick exclusively to their brokerage firm or mutual fund company’s commission-free lineup, and focus on highly liquid ETFs with liquid holdings, but they can be more meaningful to investors who do otherwise. (Frequent traders of traditional index mutual funds might also face redemption fees, however.)

Trading Flexibility: Advantage ETFs One of the major differentiators between traditional index mutual funds and ETFs is the ability to trade ETFs intraday. Traditional mutual funds--index or otherwise--can only be purchased once a day, after the market is closed and the current value of the securities in the portfolio is toted up. Investors also have the ability to customize their order type with ETFs, using limit orders, stop-loss orders, and stop-limit orders. Buy-and-hold investors have no reason to value these features or the ability to trade intraday, but investors who trade frequently will find that ETFs give them more flexibility. This article provides trading tips for ETF investors.

Tax Efficiency: Advantage ETFs Plain-vanilla, market-cap-weighted equity index funds--whether the traditional variety or ETFs--are pretty tax-efficient vehicles. (Bond index funds are not, for reasons discussed here.) Their big tax-efficiency advantage comes from their low turnover: Trading infrequently means they rarely realize and distribute capital gains to their shareholders, making them fine holdings for investors' taxable accounts.

Yet equity ETFs have a slight edge on the tax-efficiency front versus their traditional index fund counterparts. That's because investors in traditional index funds can redeem their shares at any time, which forces the manager to raise cash to pay off departing shareholders; that may force the selling of securities that have appreciated, unlocking capital gains. Investors in exchange-traded funds, by contrast, mostly trade with one another in the secondary market; that buying and selling doesn't affect the holdings in an index. For larger investors transacting in the primary market, ETFs' "in kind" creation and redemption process, discussed here, helps further enhance tax efficiency.

From a practical standpoint, many traditional equity index funds have been as tax-efficient as their ETF counterparts because they've had strong inflows rather than redemptions. But investors who are concerned about tax efficiency have an additional safeguard in ETFs due to their structure. It's also worth noting that Vanguard ETFs are a bit of an outlier in this discussion, in that their ETFs are share classes of the traditional index funds. As such, they're vulnerable to redemptions from the traditional index funds, as discussed here.

Exposure to Major Market Segments: Tie/Slight Advantage ETFs At this point, investors seeking exposure to a core capitalization-weighted index--whether it's tracking U.S. stocks, foreign stocks, or bonds, or various subasset classes and sectors--will be able to find it in either traditional index fund or ETF form. While most large asset managers have confined their traditional index funds to broad, capitalization-weighted indexes, Vanguard has tended to offer both traditional index funds and ETFs for most of the new index products it has launched. Outside of Vanguard, however, investors will find more breadth in product offerings among ETFs than traditional index funds.

Variations/Strategic Beta Opportunities: Advantage ETFs Whereas investors seeking "vanilla" capitalization-weighted index funds will find worthy representatives among traditional index funds and ETFs, most of the innovation in the "strategic beta" or "smart beta" areas have come in the ETF space. Ditto for index products that invest in multiple asset classes. And while actively managed ETFs are a small share of the ETF universe (in number and in assets), there's no such thing in the traditional index fund space.

Ability to Buy in with a Low Dollar Amount: Advantage ETFs Schwab leads the way in terms of offering low-cost traditional index funds without minimum initial investments. Yet investors can gain exposure to a huge swath of index products via ETFs with the purchase of as little as a single share. The downside of transacting in ETFs for very small investors is that commissions may apply (see above), which can take a big bite out of any gains.

Ability to Reinvest Dividends and Capital Gains: Advantage Traditional Index Funds For investors who reinvest their dividends and capital gains, the process is a bit more seamless for traditional index fund investors than ETF investors. While most brokerage firms now provide dividend and capital gains reinvestment programs without additional fees for their ETF and equity investors, the process of reinvesting dividends and capital gains is as simple as checking a box for mutual fund investors.