ETF’s vs. Index funds: The good, the bad, and the ugly
An index fund is a mutual fund that owns all the stocks in a particular index. The index could be the S&P 500, the NASDAQ 1000, the MSCI EAFE, or any of a hundred other indexes. If you want your portfolio to have 80% domestic stocks and 20% international, then you could invest those proportions in two index funds. This would instantly give you diversification across hundreds of underlying stocks. Exchange traded funds (ETFs) are essentially the same thing, but they are considered slightly differently for tax purposes. They are considered baskets of stocks instead of many individual stocks. To me this is splitting hairs, but I’m sure it’s making investment companies buckets of money. Let’s see if an ETF does us common folk any good.
Let’s compare two scenarios: investing $10,000 in an ETF vs. and index fund.
(Warning: Plot Spoiler: A good index fund is as good as an ETF; however, not all index funds are made the same.)
Two good choices: The gold-standard S&P 500 index fund is Vanguard’s VFINX. It has no load and a low expense ratio of 0.15%. The biggest S&P 500 ETF is State Street’s SPY. It also has a low expense ratio (0.10%). An ETF trades like a stock, so there is a stock transaction fee for buying and/or selling shares of an ETF. For example, Schwab charges $12/transaction. If you’re buying $10,000 of SPY, you could consider the transaction fee a 0.12% load.
Two not-so-great choices: There are many funds that track the S&P 500. Here are two: one run by Allegiant and one by Munder: AEXAX and MUXAX. The first clue to a less-than-stellar report card is that these two funds only score two Morningstar stars, whereas a good index fund will have three. (Three stars means you are tracking the relevant index, and if it’s a good index fund, then you are tracking the index — not better and not worse.) Both of these have a front-load fee of 2.5%. Why anyone would pay a load for an index fund is beyond me, but if you have a financial adviser who is paid through loads, he’ll sell you this fund and not the Vanguard fund. Both of these funds have significantly higher expense ratios: 0.62% for AEXAX and 0.60% for MUXAX.
Managing an index fund: The beauty of an index fund is that you don’t have to pick the winners — you just have to hold whatever stocks are in the index. As a manager of an index fund, your job is then focused on maintaining liquidity — buying or selling enough to invest new money coming into the fund and to be able to handle redemptions. If you don’t handle this inflow and outflow well, then you have to buy and sell frequently, driving up expenses.
Capital gains: When a fund sells stocks, it may have to realize capital gains. Mutual funds are required to pass on realized capital gains to shareholders at the end of the year, and the shareholders have to pay income tax on it. ETF’s do not have to realize gains, since all their transactions are considered wash sales (the simultaneous buying and selling of the same stock). Don’t ask me why they are treated differently. I wouldn’t be surprised if this tax loophole is closed sometime — not in the near future, but perhaps before your retirement. So another sign of a bad index fund is if they’ve distributed capital gains — this means they’re not handling their cash flow well.
Dividends: Even well-managed funds and ETF’s have to distribute dividends. When one of the stocks declares a dividend, it gets passed on to the shareholder. You really can’t get around this. However, our two “bad” funds, AEXAX and MUXAX, distributed twice as much in dividends as did the good choices. I have no explanation for this, unless they somehow bought extra shares just before the stocks declared a dividend — but that doesn’t make sense if they’re tracking an index. Whatever the reason, you’ll pay more in taxes, if they distribute a lot in dividends.
Here’s the data in a table:
| SPY | VFINX | AEXAX | MUXAX | |
| Dividends paid 2004-2008 | $11.07 | $11.42 | $1.69 | $5.21 |
| Capital gains paid 2004-2008 | $0.00 | $0.00 | $1.01 | $1.36 |
| Share Price 1/1/2009 | $89.60 | $82.51 | $7.16 | $16.29 |
| Avg. Ann. Div & Cap Gains (%) | 2.47% | 2.77% | 7.53% | 8.07% |
| Expense ratio (per year) | 0.10% | 0.15% | 0.62% | 0.60% |
| Front Load | 0.12%* | 0 | 2.50% | 2.50% |
The first two lines are the total dividends and capital gains paid to shareholders in 2004 through 2008. The fourth line is the sum of the dividends and capital gains as a percentage of the share price. This is a measure of the funds’ tax efficiency. Note that you will pay three times as much tax if you hold either AEXAX or MUXAX instead of VFINX or SPY. Yikes! That’s on top of the 2.5% load and the 4-5x higher annual expense ratios. Double yikes! And these funds get two Morningstar stars? Whaddyagottado to rate only one?!
In sum, I’d say that a well-managed index fund is as good as an ETF; but not all index funds are created equal. Watch out for the expenses. There are probably bad ETF’s out there, too, but we’ll look at that another day.
Here are some other references on ETFs: Investopedia, Motley Fool, and Queercents.
Thank you for this. I spent a ridiculous amount of time this past weekend trying to determine if I were to buy an ETF would it trade like a stock or mutual fund with respect to the fee. It took some digging, and I never did find the answer, but figured it out via the system set up.
What in your opinion is a good expense ratio range for ETFs and index funds?
Hi Holly,
For a managed mutual fund, I like to see expenses at 1% or less. I’ll go as high as 1.5% if it has tremendous performance. For index funds, I think a good target is 0.5% or less. The Vanguard VFINX is one of the lowest around at 0.15%. The ETF SPY is a smidge lower at 0.10%, but on a $10,000 investment the 0.05% difference is %5/year. I’d opt for the index fund so that I can buy and sell, as I like. I also like to dollar-cost average, so the index fund is better as it avoids the transaction fees.
Of course there may be some exceptions to these guidelines. The fees have two components: management fees and transaction costs. If the index is tracking something that has expensive transaction costs, then it might be reasonable that the index fund have somewhat higher fees. I can’t think of an example of what might have high transaction fees — maybe real estate or some exotic commodities derivatives. It’s usually management fees that drive up the costs, so it should be easy to stay below 0.5%.
Thanks for that tip, Helen. It seems kind of counter intuitive to someone like me.
Hey Serena,
Good point — it is a little counter intuitive.
When a mutual fund distributes capital gains it lowers the share price. For example, let’s say a fund is worth $100/share today. After the market closes, it distributes $5/share in capital gains, and it reduces the share value to $95. If you reinvest the capital gains, you receive 5/95 (=0.005263) shares for every share you owned. You now have 1.005263 shares at $95 = $100. (Miraculous!)
So you’re back to where you started from — except that you owe tax on the cap gains. You want the investment to increase in value, you just don’t want the distributions (if you can help it).
The ideal investment (IMHO) is something that you can invest in and not have to buy/sell or pay taxes on for a long time — perhaps waiting until retirement. Assuming of course that it chugs along increasing in value (preferably well above the inflation rate).
Unfortunately, in this scenario, Uncle Sam wouldn’t get paid for a long time, so that why he changed the rules so that he gets paid every year.
It wasn’t always this way. When I was a youngling, mutual funds didn’t have to distribute cap gains.
‘Course I also used to carry around my computer programs on punched cards. Does that give me some geek cred or what?
A kind reader pointed out that I transposed the expense ratios for VFINX and SPY in the table. It’s fixed now.
Thanks for this comparison! I have a frugal hatred of fees and notice how they squeeze the real rates of return for many of my friends. They are a pernicious dead weight in bull markets, and even worse in bear markets. My wife’s group plan investments have all made money (if you look carefully at the detailed fund reports), but it’s been sucked dry with fees and expenses. Plus, the fund is a ‘balanced’ fund of other funds – meaning that there’s the 2% management fee of the one fund plus the 2% underlying fund fees to keep drawing away the profit.
Anyway, I have a question about starting out in stocks. I’ve found that the impact of fees changes in proportion to the size of your investment. For example, a $19.99 trading fees is absurd price to buy $100 worth of stocks, but relatively miniscule if you’ve got $100,000. Also, trying to diversify your $500 portfolio is a bit ridiculous. I’ve read some news articles recently about how not enough people invest in stocks when they’re young and I think – well, duh, if you’re 20 and earning minimum wage you might have $500 set aside at the end of the year to invest in an RRSP (Canadian version of you tax-deductible savings plan). The $50/year fee to register the savings plan would wipe you out long before you ever saw any useful returns on your investment, and I really hesitate to tell anyone with only $500 in disposible income to put it in something as risky and inaccessible as an RRSP stock investment. So, that “invest when you’re young” advice is too generic to be useful.
How would you suggest someone start building a portfolio as they had increasing amounts to invest? What are the cost-effective thresholds for different products? Should they start off with one product and at some point move everything over into a different kind of investment, or approach it like a puzzle that they acquire one piece at a time?
Regan:
Great comments! You raise a lot of good questions. How about I write a post soon on “how to start investing.” It’s a great topic. I’ll also need to read up on RRSP’s — I’m not familiar with the Canadian system.
Thanks!