Today, I'd like to compare and contrast ETF's and standard Index Mutual Funds. In order to do this objectively, one must investigate the following characteristics of each investment:
- Cost Efficiency
- Tax Efficiency
Cost Efficiency:
ETFs have a lower expense ratio (operating costs) than Index Mutual Funds. Therefore, they are cheaper to hold. However, investors pay commissions when buying shares of an ETF which is an additional expense that Index Mutual Funds don’t involve. Only when ETFs are bought in large sums with low price commissions and held for the long term (aka investing) are they more cost efficient than Index Mutual Funds. Unfortunately, many investors give in to their anxiety and/or greed and start trading ETFs like individual stocks, therefore depleting any returns that they could have achieved if they had bought and held.
Tax Efficiency:
ETFs win again in tax efficiency. ETFs are slightly more tax efficient than Index Mutual Funds. This is because of how they are created and redeemed. With ETFs, most of the capital gains are deferred until the date they are sold. This advantage is similar to the advantage that tax-deferred retirement accounts (401Ks & IRAs) offer. Don’t rule out Index Mutual Funds just yet, because they are still significantly more tax efficient than actively managed mutual funds.
Note: The degree of these advantages are subject to the investor’s marginal tax rate, how long the investment was held and the return on the investment.
2 comments:
When I saw the heading here being "The Index Advantage" I immediatley thought of "Index Mutual Funds", thus "The Index Advantage" but then your first two postings today read, about the advantages of ETF's over the long term and tax wise. I was about to ask you if you favored Index Mutual Funds or ETF's and since it appeared to be Index M.F.'s why did you have two advantages of ETF's posted right there. Undersand?
Have you seen this? Anything come to mind or comments?
http://tinyurl.com/5w5khy
snip:
We asked research firm Morningstar Inc. to crunch performance data back to 1997 for some of the biggest and best-known ETFs and index funds in each of four categories: the Standard & Poor's 500-stock index, the total U.S. stock market, international stock markets and a broad-based U.S. bond index.
These are the core areas for small investors trying to build a diversified portfolio. We also examined after-tax performance data that fund companies are required to disclose.
The conclusion: Big, low-cost index funds from Boston-based Fidelity Investments and Vanguard Group Inc., Malvern, Pa., outperformed the ETFs in most of the comparisons we set up. For the 40 time periods studied, the mutual funds prevailed in 34 -- including a sweep of the one-, three-, and 10-year after-tax categories.
To their credit, ETFs sold by Barclays and State Street almost always beat the average performance of index mutual funds in their respective categories. But so did the big, low-cost index funds. Average returns for each category were calculated by looking at all of the index funds in Morningstar's database, not just those considered in this contest.
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