Choosing between a mutual fund and its ETF version depends on how far you’ll go past a break-even point
When investors have a choice between a mutual fund or an equivalent ETF, the simplest move would be select the fund with the lowest fee. Some investors, in contrast, might go with whichever has the most experienced manager. But the smartest choice is more complex.
An analysis of 66 matched ETF/mutual fund pairs — funds with the same holdings and objective — from Vanguard, BlackRock, Schwab, Invesco, and State Street showed that the ETF generally makes better financial sense, reported Dr. Derek Horstmeyer of George Mason University’s Business School in the Wall Street Journal.
But according to Horstmeyer, there are variations, which boil down to two primary factors: the tax efficiency of ETFs over the long run, and the implied cost of a bid-ask spread faced by ETFs, but not by mutual funds.
As an example, he cited the US-listed Vanguard Total Corporate Bond ETF (VTC), whose average bid-ask spread over the past month was 0.13%. Its annual expense ratio is 0.07%, implying that an investor who buys then sells the ETF would pay nearly double the underlying expenses charged on an annual basis.
“On the other hand, since mutual-fund holders buy in and out at the net asset value at the end of each day, this implies a bid-ask spread of zero and no real upfront costs due to implied exchange expenses,” Horstmeyer said.
But ETFs are generally more tax-efficient than their mutual-fund equivalents in the long term. Unlike mutual-fund portfolio managers, ETF portfolio managers are able to trim positions through in-kind redemptions, so they can avoid capital gains tax. Vanguard is an exception: through a proprietary pooling system of assets, the firm is able to deliver post-tax benefits to both ETFs and mutual funds.
In short, the bid-ask spread faced by ETFs imply upfront costs that put ETFs behind mutual funds in the beginning. But past a certain break-even point, the ETFs’ tax efficiency overcomes that drag, leading them to outperform mutual funds.
An examination of 12 of the largest matched pairs of US large-cap equity ETFs/mutual funds (by AUM) found that the average time to reach the break-even point was two months. When studying equity funds with an international or emerging-markets focus, which generally have larger bid-ask spreads, the break-even point extends to 1.2 years. The time horizon is even more distant for funds focusing on US government and corporate debt, whose average break-even point was 1.8 years.
But “if an investor faces commissions from brokerage houses or upfront loads for purchasing a product, this can quickly tilt the results in the other direction,” Horstmeyer said.
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