Wednesday, November 22, 2017

ETF vs Mutual fund? Which one is a better choice?

I am a passive investor, my portfolio is made of low cost vanguard funds and ETFs. Vanguard has some excellent choices of funds and ETFs. One of the earliest decision I had to make was to chose between investing in ETFs or mutual funds. There are lots of resources available online which discuss the pros and cons of funds and ETFs.

In this post I compare and contrast mutual funds and ETFs. This comparison would be slightly different from other resources, all my discussions would be in the context of funds and ETFs offered by vanguard. Very few investment companies have the range of ETFs and mutual funds offered by Vanguard. Fidelity jumps to my mind immediately. Schwabs is another such investment company. Additionally, all my trades are through my vanguard brokerage account. Vanguard ETFs and funds trade for free on it.





Choices:
This is a very important and limiting factor (no workarounds). Not all ETFs have corresponding mutual funds variants and vice versa. Typically, almost all index funds have an ETF version. However, most of the actively managed funds have no ETF equivalent. So, depending on your choice of investment strategy you might be restricted to only one category. For e.g. Wellington Fund (VWELX) is Vanguard’s oldest mutual fund and the nation’s oldest (started in 1929) balanced fund. This fund is not available in an ETF flavor. Similarly, Vanguard Mega Cap Growth (MGK) is available as ETF only. Almost all sector ETFs have no mutual funds equivalents.


Minimum Investment:
For someone starting out, this is definitely an important factor to consider. Typical vanguard investor funds require a 3000$ minimum investment. For the admiral funds it is 10,000$. The distinction between admiral and investor funds is in their expense ratio (more on that later).

ETFs have no such requirements. It is sufficient to have enough money to buy one share of it. If you are trading outside of vanguard, still need to pay commision (TD Ameritrade, $6.95). It might be possible to trade ETFs for free on Robinhood.

Sometimes, the admiral version of funds (mostly actively managed) can be as high as 50,000$ and sometimes even 100,000$ (for sector funds). I started out with a mix of investor shares and ETFs. If the expense ratio is below 0.20% I would be okay with holding mutual funds, if it is higher than 0.20% I would switch to ETFs (If they are available).

For example, Vanguard Emerging Markets Stock Index Fund (VEIEX) has an expense ratio of 0.32%. Even though it is high by vanguard standards, it is definitely one of the cheapest emerging market funds available. It's ETF version VWO has an expense ratio of 0.14%.


Expense Ratio:
Vanguard funds are available in three variants. The investor variant, admiral and finally institutional. I will not take institutional funds into consideration as they have minimum of $5,000,000 (e.g. VINIX). Typically these funds are available in 401k.

The investor variant has the highest expense ratio. The ETF and admiral funds have same expense ratio. Investor shares tend to be sold more often than admiral shares. Turnover (Buying and selling) of funds places cost burden on all fund owners. In order to compensate for this, investor shares tend to have a higher expense ratio. ETFs AUM is much lesser than the investor or admiral shares. The cost of selling ETFs might be less expensive to all fund holders.


Automated Investing:
It is possible to setup auto investing with mutual funds. The value of a single unit of a mutual fund is evaluated at end of the day (4:00 PM Eastern). All orders get executed after this. Typically vanguard funds values are available at around 6 PM Eastern. With a vanguard brokerage account all mutual fund and ETF transactions are free. With mutual funds, I can auto invest as low as 25$.

Since ETF is traded like a stock, it is not possible to place an automated order for it. The price of an ETF fluctuates throughout the day. It is even possible that it's price might be more than the sum of the prices of the stocks it owns (premium to net asset value (NAV)). My mutual fund investments happens automatically once a month. The new capital is split across all the mutual funds based on my asset allocation. As for the ETFs, I manually execute them on a monthly basis(once I have sufficient capital to buy a single share).


Dollar Cost Averaging:
One of the major advantages of auto investing is dollar cost averaging. I am able to average down on mutual fund losses/gains periodically. Passive investment coupled with DCA is definitely something to consider. ETF DCA is not as effective, especially if you do not have a vanguard or Robinhood brokerage account. The transaction fees could easily add up in other brokerage accounts. One way to overcome is to accumulate enough capital (lets say 1,000$) before making a purchase. This in turn reduces the time in market and makes DCA less effective.


Cost (Trading):
As I have mentioned earlier trading vanguard mutual funds and ETFs is free if you have a vanguard brokerage account. Vanguard brokerage account is definitely not the top of the line trading platform. I am unable to execute advanced orders like trailing stop order. However, for investing in passive funds and ETFs it is more than sufficient. I looked up trading commissions on TD Ameritrade account (I happen to have an account there). For mutual funds it costs $49.99 per trade (WOW!). ETFs trade like stocks, hence its 6.95$ per trade. For someone who does not have a vanguard brokerage account it might be cheaper to trade ETFs. As mentioned earlier ETFs trade for free on Robinhood.


Purchase & Redemption Fee:
Sometimes newly launched funds have purchase and redemption fee. Again, the idea here is to reduce the cost burden on all fund holders. Constant turnover (by buying & selling) of funds would increase the cost burden. Purchase and redemption fees help to minimize this turn over. However, this does not typically apply to the ETF version (probably because the AUM is too low to affect the overall cost). Once the newly established funds have stabilized, the additional fees are withdrawn.

For example, Vanguard International Dividend Appreciation Index Fund (VIAIX) has purchase fee of 0.25% and redemption fee of 0.25%. This is on top of an expense ratio of 0.35%. It's ETF version VIGI has no purchase and redemption fee. Furthermore, it has an expense ratio of 0.25%.


Dividend Reinvestment (DRIP)
There is no real difference in DRIP between mutual funds and ETFs. Both allow dividend reinvestment. It is possible to buy fractional shares of ETF via DRIP.


Fractional Shares:
It is not possible to buy fractional shares of vanguard ETFs. It is however possible to buy fractional units of mutual funds. For me buying fractional shares ties in very well with auto investing and dollar cost averaging. Lets say I have 25$ to invest in November. I could buy 0.104 units of VFINX. On the contrary I need ~238$ to buy a single share of VOO. The assumption of course is that I had already used 3,000$ to initiate a position in VFINX.


Options & Shorting:
ETFs can be used for option trading (they have the same characteristics as stocks). Here is the option chain for Vanguard S&P 500 ETF (VOO). Selling covered calls seems to be a common strategy to generate additional income. Since owning these ETFs would follow a buy and hold strategy, it might be a good idea to write covered calls. I am not an expert in either of the above strategies and I do not use them. Finally, ETFs can be shorted. Here is a link to short interest for VOO. Obviously an ETF like VOO is going to have lots of option and shorting related actions. Something like VIG might have much lesser action.


Conversion:
It is possible to convert a mutual fund to ETF. This is a non-taxable event. Need to call Vanguard directly to make this change. However, there is no way to convert an ETF to mutual fund. The only way is to sell the ETF (taxable event) and then use the proceedings to buy mutual fund.


Selling (Hold):
Selling mutual funds places a one month hold on buying (again to minimize cost for all fund holders). ETFs on the other hand don't have any such limitations.


Dividend Yield:
Finally, the yield of ETFs tend to be higher then that of investor shares. Admiral and ETFs have the same yield. The fund expenses (ER) are typically taken out from the dividends. Since the expense ratio of investor shares are higher than the ETF, their yield would be lower.

For Vanguard 500 Index Fund (Investor) has an effective yield of 1.82% (after accounting for expenses). So, its yield must have been 1.96% (1.96%-0.14%(ER) = 1.82%). Similarly, Vanguard S&P 500 ETF has an effective yield of 1.92%. So, it's yield must have also been 1.96%( 1.96%-0.04%=1.92%).

The difference in yield 0.10% (1.92%-1.82%) is basically the difference in expense ratio 0.10% (0.14%-0.10%).









17 comments:

  1. Very nice, thorough summary. To me, I really only consider two things when debating ETFs or mutual funds. What are the fees/expense ratio and does the fund meet my investing objectives. As you mentioned above, sometimes there are not comparable ETFs and mutual funds. So if you are trying to achieve one objective with the investment, you may be stuck.

    Happy Thanksgiving!

    Bert

    ReplyDelete
    Replies
    1. Happy Thanksgiving Bert! Actively managed funds seem to be missing ETFs. Thanks mate!.

      Delete
  2. Hi DG, Excellent analysis on the pros and cons. I think both funds and ETFs can have a role in a diversified portfolio and I do own both. The fees on actively managed mutual funds do bother me since it is so important to keep investment costs low in order to maximize returns. Tom

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    Replies
    1. True mate! My portfolio is a combination of funds and ETFs too. I own VGHCX, which is actively managed.

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  3. Nice summary! I own Vanguard ETFs in my 529 plan. I've switched entirely to investing in individual stocks in my personal portfolio. I'm with Schwab though so do have access to the excellent selection of low cost ETFs that they offer (in addition to Vanguard ETFs). I do need some more exposure to emerging and international markets so might invest in ETFs there to get more diversified exposure to a sector that I'm not as familiar with.

    Scott

    ReplyDelete
    Replies
    1. Schwab has some awesome ETFs. I don't want to slice and dice too much, but have some international exposure is good. Check out VXUS or VWO.

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