What You Need to Know Before Buying ETFs (Part 1)

Transitioning from mutual funds to ETFs for their low costs and tax efficiency is tempting, but some of these advantages may be exaggerated, says Vanguard's Joel Dickson.

Christine Benz 08 April, 2016 | 9:21
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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Exchange-traded funds have taken off in popularity, leaving many investors to wonder whether they should abandon their traditional mutual funds in favor of ETFs. I recently sat down with Vanguard's Joel Dickson to discuss the factors they should consider first.

Joel, thank you so much for being here.

Joel Dickson: Thank you for having me.

Benz: There has been a stampede into exchange-traded funds, and certainly there are some benefits touted. I'm wondering if we could talk about what you view as the key advantages of ETFs versus traditional mutual funds and then maybe some of those advantages that perhaps are a little bit overblown, especially depending on what type of investor you are.

Dickson: I think there's been a lot of discussion certainly about ETFs and funds, and I think a lot of times there is confusion about what truly are the differences. The main difference is really one about how people access the shares. With a mutual fund, you are investing directly--or maybe your advisor is investing directly--with a mutual fund company, whereas with an ETF, it's largely through a secondary market--on the brokerage or on the exchange--where investors are buying and selling shares. And that leads to some differences in the accessing of the shares themselves.

Ultimately, whether it's an ETF or it's a mutual fund, they are wrappers for underlying investment strategies. And by and large, the majority of ETF investment strategies have been index-based--they are seeking to track an index of some sort, whether it is a standard cap-weighted S&P 500-type index or whether it might be so-called strategic beta or smart beta alternative indexes. It's what we would call rules-based active approaches. By and large, however, the traditional mutual fund industry has been built up from a sort of active-management standpoint. So, still, the typical mutual fund is a security-selection active-management investment approach; the typical ETF may be an index-based approach. That's part of the issue of is it ETF versus fund or is it active versus passive, and I think a lot of the discussions of the advantages--or supposed advantages--of ETFs are not so much about ETF versus fund, but rather active versus passive.

We talk about ETFs as potentially being lower cost or potentially having a little bit better tax efficiency [especially for U.S. domiciled ETFs], and while there may be some mechanics in the ETF that work a little bit differently that can enhance tax efficiency at the portfolio level, by and large, what we know from the traditional mutual fund universe is that index products compared with similar active products have at least historically tended to be more tax-efficient. So, is it an index/active story or is it an ETF/fund story? And that goes also along the lines of cost.

In fact, we did some research a couple of years ago that showed that the average expense ratio in index mutual funds is actually lower than the average expense ratio in ETFs. But yet, overall, if you just take the category of mutual funds, ETFs are lower cost than mutual funds; but when you compare index to index, actually traditional mutual funds on average were lower. So, it's not so much this ETF/mutual fund story as it is active/passive; it's the underlying investment strategy and how you access that.

Benz: You've hit on costs a couple of times, and certainly when anyone's looking at any type of index product--whether traditional index mutual fund or ETF--that's an important consideration. But one thing you wrote about in a recent research paper was this idea of the various costs that you pay as an investor--the direct fund expense ratios as well as trading costs that you might incur. You had a nice grid in the paper where you helped investors think about their break-even costs and how these two sets of costs work together. Can you walk us through the thinking behind that grid and how investors can sort of put this decision-making into action?

Dickson: Sure. There are really two separate categories of cost that you think about with ETFs, funds, investment products. One is the ongoing costs--think of that simply as the expense ratio. You pay that each and every year. Then there's the acquisition cost or the transaction cost, and you pay those at the time that you are transacting or acquiring or selling shares. So, it may be that the mutual fund, let's say, for example, has a higher expense ratio than an ETF that you're looking--both have similar strategies. But you may have to pay more to acquire shares of the ETF because you are doing it on a brokerage platform--you may have bid-ask spread costs, you may have commission costs in some instances.

So, how do you compare, then, the total costs of buying and selling the ETF, knowing that the transaction costs at the time are higher, but the ongoing costs are lower? In that case, there is a break-even; if you're holding it for a short time period, you're not going to get the benefit of the lower expense ratio over time, and it will be dominated by the higher current transaction costs.

On the other hand, the longer that you hold it, the more that you, in essence, are spreading those transaction costs over the longer holding period, and then the expense ratio difference can then make a larger difference. So, that table that we have in the research paper looks at different combinations of the differences in expense ratios versus transaction costs. And to a certain extent, you can look at this break-even by considering any two investments. They could be ETF versus fund; they could be ETF versus ETF; they could be fund versus fund.

Just looking at the difference in expense ratios divided by the difference in transaction costs--where both are, say, a percentage of the investment or basis points--gives you the break-even in number of years for which of those two products would be more advantageous given the holding period that you expect for your investment.

 

In part 2 of this interview, we will explore the aspect of trading costs as it pertains to ETFs. 

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About Author

Christine Benz  Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

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